Hello, Specs

A while ago I was asking directions and opinions about Artificial Intelligence and Machine Learning applied to the Markets, and the answers were quite discouraging.

Nevertheless, inspired by works such as of Marcos Lopez de Prado, (who is now Head of Artificial Intelligence at AQR, if I recall correctly), I started my Masters Degree at Computer Science, with focus on Machine Learning for trading (UFRGS - Universidade Federal do Rio Grande do Sul).

The reason I'm telling you this is because what I'm learning differs from the overall view I got from the answers to my previous query.

I now see that the answers were in line with the idea of webscrapping for "market humor", and news analysis (all int he field of Sentiment Analysis), etc.

There's no dispute that this approach is not available to retail investors such as I, nor for minor asset managers. In fact, I would argue that Bloomberg and Reuters (or any other news agency) would have dominance on that.

(The same is the case with the so-called "high frequency trading"… We simply can't compete with the major players).

But, I'm also learning that Machine Learning (and Artificial Intelligence) is much broader, and I'm starting to see its relevance for trading… Specially, automated trading.

My first model developed at the Masters used an algorithm called Support Vector Machine, which is a classification algorithm.

There are three main "approaches" do Machine Learning: Unsupervised Learning, Supervised Learning and Reinforcement Learning.

SVM (short for Support Vector Machines) is an algorithm in the category of "Supervised Learning".

That's because you give it some features to work with (and learn from). These features are our own market analysis filters, whichever they are.

The thing is, the main value in this model comes not from the SVM algorithm itself, but the "feature engineering", i.e., from "which data filters should the algorithm learn".

That's useful to any (of us) who has his own trading style developed from the experience of many years: we intuitively (or through massive research) know what would be useful or not to develop a trading strategy.

Anyway, I'm still in the process of getting this Masters Degree (in Computer Science), and it's my goal to develop a new trading model from each algorithm I learn.

If you, Specs, have interest in it, I can have you posted.

Kind Regards from Brazil,

Newton Linchen Certified Analyst (APIMEC, CNPI-T 2167).




Just wondering if any of you have been doing anything related to Machine Learning for modeling the markets?

Years ago, reading The Education Of A Speculator, I learned that Victor was not fond of Neural Networks and the like.

Anything changed?



Mr. Isomorphisms writes: 

You're quite late to the party if just starting.

qplum.co was at a supposed quant conference claiming he had the greatest returns (at the youngest age) of any Tower partner. I was skeptical. For reference the same conference had a bloomberg guy claiming sharpe >5 to a twitter signal (whoops, trading costs not included. Wtf)

2-3 years ago finance bros were all over NLP looking to beat the market. Now the papers are out from that movement. arXiv has turned itself inside out with DL + markets nonsense. I feel like this (and even DL) jumped the shark several years ago. If you want to learn about NN, read Eugenio Culurciello's post (originally on his github) on neural net architectures. The big advances in image recognition were due to flickr users tagging massive amounts of data.

S Mallat and R Vershynin have done some good work in the last 5 years while everyone else is going crazy. Even N Matloff is apparently caught up in the eddy, making points about NN that L Wasserman published 20 years ago. Francois Chollet is moving on. You should too, unless you have a good reason not to. As someone else mentioned, tensorflow, caffe, model zoo, are good fun to play with, if that's your only goal. otoro.net made some fun video games with convnet.js. Think a little more creatively, like that, if you want to play this game.



In trading stocks (and stock index futures) I'm finding most useful to put things in a proper framework, so I can compare apples with apples.

I'm working for a few months with a seasonality framework for the daily changes, within a month.

Taking the last month's close as the "Equator Line", I would divide the month in 3, having, thus:

1: The first third of the month, while above last month's close (LMC);

2: The second third, above LMC;

3: The third and final period of the month, above LMC;
-1: The first third, but below LMC;
-2: The second third, below LMC;
-3: The end of month (3rd third), also below LMC.

What I found is that a daily change of - % or + % has different significance in each of this "seasonality sectors".

One two-day strategy I was researching showed profits only at the -3 (end of month below last month's close).

Some strategies show profits only in sector 1, or 2, etc.

The rationale behind it would be the mutual fund industry, which have to release a monthly report, therefore having the incentive to buy in the end of a bad month, to give a least horrible report, etc.

But I could be lulling myself into error, so I would like the Specs contribution.



Probably you all know it, but I think it's worth to share: I'm using since last year a nice software, Evernote, to help me handle all the scattered notes I once had in written notebooks.

It's free (I have the free version — didn't see yet the need to purchase the full version) and I'm really delighted.

One thing I always do is to read "old" pages of the Spec List (all the previous years) and save the ones I want in the favorites. Now I can clip them to Evernote and read them offline, while adding notes, etc.

I'm using it also to collect research notes, register thoughts, and so on. It's like having a secretary to do just that.

Here's the link or download.

It's worth a closer look. (And the mac interface is gorgeous).



Look at this chart. It's the Ibovespa Futures Contract (mini).

The (mini) lobagola move and subsequent extreme noise occurred in only ONE SECOND. The rest of the noise occurred in one minute.

The chart depicts 10 tick bars.

There was unprecedent volume.

The times and sales showed LINK, a HFT Institutional Brokerage Firm (now owned by UBS, and open only for institutions and foreign investors), as the solely buyer during the up move, and the main seller during the down move (during noise period).

Again, this took place in ONE SECOND. It was 10 A.M. (New York time), during the release of US economical numbers.

Talking with a wise Computer Science player, this is possible only if you have:

1. Hardware programming (chip);
2. Extreme co-location at the Exchange (he used the term "into the Exchange mainframe").

It's scares one to death, as reminds us the 2010 flash-crash (which sounded to me as a "market nuclear bomb test".)



 I am reading Ari Kiev's book The Psychology of Risk.

He argues that goal setting is most important in trading success. Instead of trading passively at what the market offers, one should first set his own goal, then develop a strategy based on the goal, commit enough risk, and trade with faith toward the goal.

Does anyone have any experience or thoughts in this approach?

Gary Rogan writes:

Leo, I just found it interesting that the language sounds like the industry-standard language of "financial planning", other than the faith part, in that that language involves "understanding the customer's goals", "finding their risk tolerance", "establishing a plan to achieve the customer's goals based on their risk tolerance".

Does he believe in some sort of "you dial the risk, you'll get the return if you believe hard enough" kind of thing? As he explains it, is the purpose of "faith" so that you don't chicken out when things get tough or as something else?

Ralph Vince writes: 

From the time I was 19 or 20 years old and a coffee-cranked margin clerk, until now, I have witnessed that the number one determinant of success or failure is a defined criteria (or lack of).

As Kerouac put it:

Two flies, You guys, What are you doing here?

So what are you doing here? If you're just here "To make a better return on your money," you may want to give your criteria a little better consideration.

What are you willing to accept as risk, how will you contain the risk to that? What's the time horizon? (the most overlooked aspect in investing, bar none. We live on a planet of delusion where people are using asymptotic, long-run values which often diverge greatly from the reality of finite time).

Pension funds are able to do this — articulate their criteria, as well as anyone. They need to keep to a specific liabilities schedule. Institutions tend to trump individuals in this regard.

You can tell the compulsive gamblers — the individuals without a specified criteria, disaster is imminent.

So…what are you doing here and when do you need to get it done by?

Gary Rogan replies:

But Ralph, and I'm not at all trying to be facetious, what if I have a hundred bucks, willing to lose fifty and want ten million in a year? Aren't your capabilities/means/methods at least as important as all the other factors put together?

Ralph Vince replies: 


Ha! Maybe your plan is a deep OTM option….parleyed 6 times in a row, with half the $100 ?

Without a specific, detailed, articulated criteria, I cannot determine my exposure plan. I don;t have control over what the markets will do
– I DO have control over my exposure.

The whole thing gets you out onto that lumpy landscape I call leverage space, and without getting into the nittygrittynasties of that (and acknowledging you are IN leverage space whether you like it or not, and it is applicable to you whether you acknowledge it or not), let's say your criteria is exactly as you defined. Well that sounds like some sort of portoflio insurance, yes? Your strike price on that is $50. Now, given that there is a peak to leverage space, portfolio insurance runs from that peak (as a % exposure) to 0 (as a % exposure) as your equity decreases to $50 (where your exposure is 0).

So now, given that you have articulated a criteria, you can plot a path through leverage space. In other words, you can create a specific plan to achieve that criteria in terms of your desired exposure.

Leo Jia adds: 


I am only a quarter into the book, so still can't comment on all your inquiries.

You are right, it does sound somewhat similar to the financial planning language. The difference perhaps is that the goal is meant for a daily goal or very short-term goal. It should be set at a level as high as one can stretch. One should clearly envision the realization of the goal to make sure that he WILL achieve it. Only by doing this, one can be ensured to devote all his power to achieve the goal.

The faith is to ensure that one does not get chickened out easily. It helps one to steer away from common beliefs one grow up with, such as staying safe.

Victor Niederhoffer writes: 

The power of prayer in markets and life for extending life and gains was well studied by Galton who noted that insurance companies did not reduce the rates for boats owned by divines nor was their life expectancy greater.Having faith in a market reaching a goal, will not alter the counts as to whether to hold for the end or the middle or the reverse. It will just cause unnecessary vig.

Leo Jia asks: 

What about the faith not in a religious sense? Shouldn't one have faith in oneself, in one's well-designed strategy, and in one's ability to reach the goal?

Ralph Vince writes: 

I return to this thread, which, despite it sounding like a hokey, self-help sort of thread, is, as I mentioned, the single-greatest determinant I have witnessed through the peephole of my own experience watching and participating in the trading world. It is what transforms those who are lured here for all the wrong reasons, into dull successes at this endeavor.

Especially as an individual trader, it's so easy to get sidetracked, derailed, spun around and disoriented by the markets. And if we agree that quantity is, over the course of N trades, at least as important as direction (the latter of which we don;t have much control over, and that a gentleman's bet and betting the house — the spectrum across there determines the weight of the specific risk on us), and that quantity is specified by a plan to achieve our criteria, then it is exactly the execution of that "plan," which becomes the vital exercise in trading. And without a goal, without specific, well-articulated criteria, you cannot craft the plan to execute — you are just waffling, flailing.

(And these goals the individual can craft should be more clear than that specified by the investment committee of an institution, because as individuals, you can set a higher bar than a committee of bureaucrat-types).

The exercise then becomes one of executing the plan, something quite boring and clerical, but, to me, something that has resulted in extreme trading success. I won't elaborate further, there are plenty, always, not experiencing success and my aim in this note is to point them in the right direction to achieve one pathway to that success (as I believe there are likely many, though I am only familiar with this one). Granted, I am very familiar with the linkage between achieving a criteria, specifying a path to achieve it, in terms of simple mathematics, but this is not something someone cannot learn and familiarize themselves with to a greater level than i have.

Since doing so, I have encountered success with this that I did not think was possible. The execution of the plan turns you into a trading apostate, relegating most market-related exercise, entry & exit, selection, etc., to their rightful place as secondary or tertiary concerns, contrary to what most believe.

No, I'm not going to detail my specific plan — it's unique to the criteria I am seeking to achieve, and the point of this note is to further highlight the critical importance of criteria and plan. Along these lines, what I later found echoed what I was discovering about my plan in a book called "Great By Choice," by Collins and Hansen, specifically the "20 Mile March" notion as it pertains to specifying such criteria-plan relationships as detailed here for trading and their execution.

I doubt most will bother with what I write here. Growing up in the raucous world of Italians and Jews and their gambling, the lure of a little self-created danger and excitement — the little rush of that, is what draws most to this arena and keeps them here, though they don't see it that way.

Gibbons Burke writes: 

Great post, Ralph. It brings to mind CompuTrac/Telerate's Teletrac software, which was originally named TradePlan. It was built to facilitate putting into practice the old Frenchman's wizened admonition "Plan your trades, and trade your plan." Unfortunately it was a bit weak in an area you championed, sizing your trades appropriately, but in many other respects its design remains one of the best for indicator and rule based analytics.

Ralph Vince writes: 

And, if the Chair will grant me a pardon just this one last time (regarding the French, a topic of seemingly poisonous exosmose to our regarded Chair) the number one rule I have learned of the markets and life: "Never face the Old Frenchman. Never. In anything."

Leo Jia comments: 

Hi Ralph,

Thanks very much for the inspiring posts on this thread.

Your point (if I understand correctly) is that the single purpose of a goal is to define the size of the trades. I understand size is very important but am not very clear on how exactly a goal works on that.

According to some literatures (yours as the most prominent), size is determined by how much one want to lose on each trade based on his strategy, and to win more, one has to increase the size, but there is an optimal size beyond which one's return will diminish. Isn't all that simply mathematics and how aggressive one want to be? How does a goal serve here?

On the other hand, how aggressive one want to be is very much influenced by his faith (or his illusion) on how successful his strategy will be. A key question I often have is how one can be so sure that his strategy will work as tested so that he can simply increase his size to the optimal level in order to maximize his return? And this doubt also applies to execution.

Would you kindly explain?

Ralph Vince responds: 


You're asking me to explain an awful lot, too much for a simpled response I fear. Let's say there is a risk proposition, a potential trade or wager. If I am going to play it one time, what I stand to make as a function of what I risk is a straight line (from a gentleman's bet, i.e. risking nothing, where f, the fraction of our stake we risk, is zero, to risking the house, f=1.0, where the line goes from 1, that is, risking nothing we make a multiple of 1 on our stake after the proposition, to some value > 1 where we risk the entire house).

For a subsequent play, where what we have left to risk is a function of what ocurred the first play, a curve begins to form (and thus you can see how the notion of a "horizon," that is a finite number of plays is an important parameter in all of this). No longer is the peak at f=1 when we have more than 1 play. The peak begins to move from 1.0 in the direction towards some value > 0 .

And I can show mathematically (because this is NOT a story about may, but about graphic visualization) that, absent knowing where that peak will be in the future, that the long-term best guess for this peak is p/2, that is the percentage of winning periods divided by 2. If I expect 50% of my plays or periods I have a position to be winning, then the best guess for this peak is 50% / 2 = .25. I am not going into the mathematical reasoning behind that here.

There's more….a lot more now. A curve has formed. The curve has a shape, and the story is in the shape of the curve and all the geometrically important points therein (I have catalogued these and discussed them at length to a disinterested world). And you are neccesarily on this curve when you trade this instrument, whether like or not, acknowledge it or not, and likely moving about this curve — and you are paying the consequences and reaping the benefits of where you are on this curve.

And here's the thing — you have control over where you are on the curve, and where you are moving on it. You don;t have control over the trade. And the thing you have control over is the difference between a gentleman's bet (where nothing is at risk) and having your entire life at risk.

Now, you have a criteria. Someone asked earlier on this thread for a particular criteria, which sound like a sort of portfolio insurance, and thus, a path can be plotted on this curve to accomplish precisely that.

There's a lot more to the geometry of this, and the paths on the curve (or surface in N + 1 dimensions, where N is the number of components you are trading), but people prefer to be blind to this but they do so at their peril and cost.

Newton Linchen writes: 


When I finally understood Kahnemann's proposition, that people (including and - specially - me) are not "risk averse", but "loss averse", and later recognize that was this "loss aversion" that caused me to lose more than I needed to, (since I have always researched trading strategies), the next logical step was to dive into your work.

I'm now at the point of embracing your ideas about the leverage space "for good", because I finally realized that trading requires so much toil… that it's simply not worth it if you don't aim for the maximum goal.

In other words, trading is difficult regardless of anything else… So why not do it for the maximum available profit?

That of course, requires courage, since humans have a great deal of loss aversion - and it's only possible when one realizes that it's just not worth it if you don't aim at the zenith.

Ralph Vince writes: 

If you want to Newton, and you have the stomach for it. If that's your criteria — growth maximization and drawdown be damned, then yes, you want to be at what you expect the peak to be over the future horizon of holding periods you are going to engage over.

Me, I'm old and cowardly. I like to sit on park benches with a shawl on…


These are already things everyone is already doing, i.e. they ARE moving around in this leverage space, like it or not, likely moving about it, paying the consequences and reaping the benefits of a location in a geometry which has extreme bearing on his fulfillment (or not) of his criteria. Your guy employing the mean variance approach has, as his criterion, maximizing expected (1 period!) gain with respect to variance (usually within some specified other constraints, like without using margin, without more than x% in any one group, no short sales, etc). He is still invariably in leverage space, moving about it. (Further, in assuming the main facet of his criteria, maximizing return vis-a-vis risk, wherein he specifies risk as variance in that return, is mathematically misguided as variance is a diminution in [consecutive] return, and not risk, i.e. it is already baked into the return portion, i.e. the altitude in leverage space, as one considers consecutive return [i.e. reinvestment]).

It's not a matter of maximizing return, alone or with respect to something — unless that is ones criteria. Regardless, we are in leverage space, moving around, and can craft our plan our path through or stationary location within this space to satisfy our criteria.

And, absent a criteria, a "goal," the virtue of which was questioned at the trailhead of this thread, there can be no plan as nothing is being sought (other than perhaps entertainment or some form of self gratification). And if one does have a goal, a plan can be crafted to try to achieve that goal.



 While watching a Mark Douglas trading psychology seminar (dvd), I remembered the discussion about whether financial time series were dependent or independent (sample without replacement x sample with replacement).

He makes a good, clear point, although talking from another framework:

"There's no connection with the outcome of this "now" moment opportunity with any opportunity in the past - even if you're using the same signals: the traders that are operating in the market now are not the same traders that operated the last time."

It's so simple we (I) forget it.

The idea seems to be this paradox: while it's impossible for every trader, investor, manager to be at the same time doing the same thing as before, (and therefore previous opportunities are not related to the present one), somehow the edge as defined by your work (statistical, technical, fundamental) will remain its winning % and manifest it in a series of trades.

The paradox is that individual trades are random, while series of trades maintaining the edge win%.

So his advice is:

a. Have a system

b. Follow the system without emphasis on the distribution of individual trades.



Once in a while we all like to engage in charitable efforts. Even if it means to "preach in the desert", trying to make technical analysts realize the unprovable nature of their beliefs.

Facebook is the greatest of deserts, if you look through this point of view. (So are traders "forums").

But well, we all want to go to Heaven, so we tried a little effort of preaching.

The analyst's rage was unleashed!

(The funny part was to acknowledge that he took our advice of "drawing a uptrend line with a ticker line so it was less susceptible of being broken" seriously, as a real advice!)




Hope everything is well with you.

I've been tempted to sell that Mark Twain gold coin you gave us one Xmas. At current values, it could finance a round trip flight for Janis and I to Italy. But if it keeps up its current pace and housing values continue to crumble, we probably can buy a second house with the one coin in a couple of years.

I had an idea for you to explore. I doubt if it is "Daily Speculations" - worthy, but i wonder if it has some bearing on your trading theory of "ever changing cycles."

It's based on this game.

I call it RPS intelligence. if you can consistently beat the computer at that game, you might be a good candidate for making money in the stock market. The computer detects patterns in your play and bases it's choices on your previous play. Substitute stock market (or S$P futures trading floor) for computer and you have a good game based on your "ever changing cycles" theory. That is, if investors become too reliant on a trading strategy that what works in the past, the computer or market detects their pattern of play and beats them.

If someone has strong RPS intelligence, they might do well as a trader in the market.

Anyway, I hope you are doing well. We've been expanding our book business so fast that we have to hire a couple of people. Having to manage people is not my strong suit, but maybe Janis can keep employees happy.



Newton Linchen comments: 

I always enjoyed this game, although I was never good at it. So I took the challenge to play with the computer.

My best score so far is 46 x 36, with 33 ties. This is the 10th time I play in the past few days, and the other 9 times I was "cleaned" by the computer.

I don't know whether this relates to markets or not, but the thing is the computer "learns" your (mine) style and adapts to it. So in order to beat it, even with a small amount of winnings, it's de rigueur that one constantly monitors when the computer starts to win hands it didn't win in the previous throws.

Consider a tie: paper-paper. My first (and dumbest) strategy was to attack: next hand I would give a scissor. It responds well to attacks, in fact, it seems by default to expect that the player will attack. Therefore, I soon discovered that the dumbest strategy was to attack the computer's last hand. If it's hand was a rock, you couldn't win throwing a paper, and so on.

So, in the event of a tie, I changed my strategy to playing again and again the same hand (say, "paper"), and so the computer. It usually goes three ties until it takes the attack. But it would attack (change from "paper" to other) counter-attacking: he would throw rock (expecting you would have attacked with scissors). Therefore, the strategy of waiting for the computer to attack was a win.

But it learned this move too…

And afterwards in the event of a tie, if you played the same hand, it would start to attack using the direct approach: giving you a scissors.

And that was an example of the multiple learning processes the computer went through, beating me in the previous 9 times.

(It was starting to annoy me: was it reading my mind? : )

I tried the random approach, choosing paper, scissors or rock disregarding the last hand. Say, throwing paper-paper-scissors-rock not even taking in account what was the computer's last hand.

It worked. For a while… (It seems the computer was also good in dealing with this).

This last game, when I won in 108 throws, maintaining a +9 score during the entire play, I tried three different approaches:

First, trying to lose to myself: If my last hand was a paper, I would throw rock in the next hand (rock loses for paper). Bingo. It worked. Then again, and again, and again. Example: paper, rock, scissors, paper, rock…

When the computer started to adapt to it, I would play "losing" to it: if the computer's hand was scissors, my next hand was paper. And it also worked.

Also adapting to it, after a while, we would have a tie, or I would lose.

If I lost, I would choose at random the next play.

If we had a tie, I would alternatively: a) play the counter attack: tie = paper-paper, my next hand was rock. b) play the direct attack: chose scissors.

The only way I could manage to stay +9 over the computer during the game was alternating at random these three main strategies: losing-to-myself, losing-to-the-computer, choosing at random after a loss, and playing the two "tie" approach.

After a string of winning hands, I would change the strategy after one loss.

Then win or lose.

If winning, I would press that win keeping the strategy, until one loss. Then change again.

PS: The way I don't think this game relates to speculation is that we are trying to be the market, ever-changing, running away from the smart spec who is trying to figure us out.



I'm reading old posts on Daily Spec, specifically an interesting discussion on the topic of Stops, that took place in 2003.

At the end, Faisal mentioned a paper of Dr. Eric Berger on calculating the probability of hitting the barrier (stop or price of the knock-out option).

Could anyone share this paper?

And, any other improvements on the discussion?

P.S. What I find difficult in those answers about not using stops, "no stops required", "stops will double your probability of loss", etc, is the time horizon. We have to give profit to our clients every month, otherwise they will fly away to another firm. How does a "no-stop" policy deals with this? And… in the event of a year such as 2008, (or 2011, in Brazil), a no-stop approach isn't a sure path to greater loss?

And for those not using stops, what's the time horizon? Do they NEVER take a loss? When will the loss ever be taken? (They put that part of their portfolio in a box, never to look at it again?)

Phil McDonnell writes: 

In introductory Stat there is almost always a section on calculating the probability of a certain sized observation in a normal distribution. That calculation tells you the probability of being at or above a certain level after a fixed period of time. To calculate the probability of having touched that level at some time during the fixed period of time simply double the probability. The reason is the Reflection Principle. For every path which wound up past that level, there is an equal and opposite path that was 'reflected' back from the level.

The same thing applies to stops on the downside. Note that all of this does not assume an infinite time period, but rather a fixed period of time - kind of an investment planning window if you will. The reason for this is that the variance always grows as time is extended. Given large enough variance then almost any price will be hit eventually both up and down.

Newton Linchen replies:


This is the subject that I have read several times in your book, but still can't imagine how this would fit someone who must give monthly performance reports, instead of a well-capitalized investor who can stand some period in the red…

This approach doesn't seem to fit short-term trading (trading with less than 30 days), unless you exit the position until the end of the month, which would be your final "chance" for the position to work.

And in the time horizon of one month, one would have to ensure protection against the ineluctable downside.

Phil McDonnell adds: 

The main point is that stop losses will double the number of losing trades at your 'maximum loss' level. So you will report more losing months. Is that what you want? So if not stops then choosing a prudent position size for a trade is really the way to control risk.

Most of my comments are made on the theoretical basis based on what should happen. But in fact in my empirical tests, reality is worse. Using stops actually hurts expected returns in most cases. Theory says that should not happen. Theoretically expectation should remain unchanged if you use stocks but that is not the case.

Attached is a little table excerpted from Larry Connors and Cesar Alvarez's book Short term Strategies That Work. It shows that for a particular simple system the average P/L was .69 per trade. with 69.81% winners. But when you add a stop at the 1% level the return plummets to .19% and only 26.89% winners. For all stop levels tested up to the 50% level the returns were lower when one added stops to the strategy.

So looking at probability per trade and return per trade stops seems worse. But theory says that they may help by reducing variance. So far as I can see that is the only good thing about them.


Dave G writes: 

Hedging makes more sense than the antiquated and disgraced use of "stops".



 One would imagine the Sunday open to close in Israel might be predictive of the open in the US on Sunday night, and possibly the open to close of us on Sunday. By Israel open on Sunday, the US has already passed Friday close. And Israel would be catching. Of course the US Open is not a predictive thing since it can't be acted upon, but a descriptive one. The whole subject of the influence of Indian, European, Asian, and mideast markets on the US is an interesting one and calls for much counting, correlation, and finesse.

Anatoly Veltman writes:

I'd be the first one to stress the equities "rolling wave" over the timezones, as well as inter-market influences (as in currency-gold-stocks-bonds-oil, etc). Being said, there are two clear new ingredients that make historical statistics less than meaningful: central meddling and modern algos.

1. What can possibly be the use of percentile correlations and sequences observed over any historical duration, if current market interventions and near-global ZIRP are unprecedented.

2. Modern algos thrive on constant change/adjustments. To paraphrase Jim Simons: what feeds "our" fascination is that our former immersion into discoveries (within pure science) would eventually yield an ever-lasting law or theorem — while (market) discoveries we achieve today will only live a blip of time, and so you have to journey on (almost daily) to your next discovery and implementation.

So in consideration of the above major influences, my current MO would be: do not rely on hard stats. Do rely on your instincts, understanding of the new world financial order and good occasional privileged information — and trade discretionary.

Chris Cooper adds: 

I can accept Anatoly's "two clear new ingredients" but reach different conclusions. My conclusions are:

1) Trade at a higher frequency so that you can get enough recent stats to be meaningful.

2) Trade fully automated, not discretionary, so that you don't fool yourself about your alpha. Also, it's the only sensible way to trade at a higher frequency.

"Relying on your instincts and understanding the new world financial order" are important only at the meta-level.

Paolo Pezzutti adds: 

I think:

1. Cycles are ever changing. Today it is because of ZIRP, tomorrow it will be because of new rules or products coming on that influence market structure. I don't know if cycles will be shorter or longer. You trade them until they work. Counting still works.

2. Frequency depends very much on commissions. Some regularities at shorter time frames cannot be traded if your commissions are too high. Frequency depends also on technology you have available. Also, one should trade a frequency where you have less competition.

3. New cycles means new patterns to come up and old patterns to die. Keeping track of ongoing patterns is important and also establishing criteria to determine a pattern has stopped working. Early discovery of new patterns is vital for your performance. But how much data and evidence do you need to validate a new pattern? More importantly on the tech side is how you implement the search of new patterns. A continuously running search can scan the data according to certain criteria and propose pattern to be evaluated further.

4. Trading should be fully automated to trade higher frequencies, more markets simultaneously, and decrease stress.

Newton Linchen writes: 

Dear Paolo,

You said: "Keeping track of ongoing patterns is important and also establishing criteria to determine a pattern has stopped working."

I once asked this question (how to measure the "death" of a trading strategy) to the List, and the answers were disappointingly vague. ("They work until they don't anymore", and such kind of answers).

To my knowledge, this is a vital question.

Recently, I backtested a strategy a colleague was trading, to discover that in the last 6 years you would lose your entire wealth trading it. But he kept trading it, due to an anchoring with an event when "it worked", plus a kind of empirical testing of only few months.

This means he was caught by the siren song of a series of "lucky strikes" within a larger distribution of years of losses.

This behavioral concept ("anchoring") is quite interesting, and we smile at the poor guy who don't count.

But what concerns me is that we can behave the same way, (although counting), when we face a regime shift (ever-changing cycles) and keep trading the defunct strategy… Until when?

Perhaps a rough answer would be to establish a drawdown metric related to the maximum historical drawdown? (i.e., we trade it until a drawdown x% larger than the greatest historical, and then quit?)

Or maybe the reason to trade a strategy must be quantitative whether the reason not to trade it anymore should be qualitative? (i.e., acknowledgement of the regime shift…)

A final thought would be a strategy based on market microstructure — in the way it is present in ALL regimes.

Any thoughts?




 After 5 years or so, I finally got to the point of confidence in conducting basic quantitative studies. (Very basic…)

While reading again Philip's book "Optimal Portfolio Modeling", I got stuck in the following sentences:

"Professor Niederhoffer was just such a divergent thinker.

His help and guidance taught me to see things at their simplest. That is the essence of his approach. His enlightenment also helped me to learn how to avoid the numerous pitfalls that can arise in quantitative studies. *In fact, one of the things he taught me was what not to do on a quantitative study*."

I couldn't help to think what such advice would be…

And what the Specs thinks of what one should avoid while performing any counting studies.

Steve Ellison writes: 

Be very careful to consider only information that was known at the time. For example, when doing a study that uses the high price of the day, you cannot know that any price will be the high of the day until after the close. Similarly, you cannot act on the closing price or anything based on the closing price, such as a moving average, until the next day.

Beware of data mining bias. If you test the same set of data enough times, you will find some results that appear to have statistical significance, but occurred just by chance. For example, I analyzed the most favorable trading days of the year. There are an average of 252 trading days per year, so one would expect 12 days to have results with p<0.05 just by chance. You need to control for data mining bias either by setting a more stringent p threshold or testing out of sample. Any time you have considered multiple strategies and selected the one with the best results, you should assume that part of the good result was by luck and expect worse results going forward.

Statistical significance is not necessarily predictive. In an era of much quantitative analysis, a regularity may not last long. It has happened more often than I would expect by chance that I found a pattern that was bullish or bearish with statistical significance, and the out of sample results were statistically significant in the opposite direction.

Bruno Ombreux writes:

Data mining bias can be experienced in the most vivid manner with the new Google correlation engine. It can come up with some of the weirdest, actually impossible, correlations. Google correlation results are more illustrative and striking than any theoretical academic stuff about multiple comparisons.

Phil McDonnell writes:

An incomplete list of things NOT to do on a quantitative study:

1. Avoid retrospective data. Many fundamental data bases have retrospectively adjusted data. sometimes the data is adjusted years after the fact and could not possibly be known at the time.

2. Avoid retrospective price data. Many so called quants pat themselves in the back for 'correcting' their data after the fact. Any valid study must include the data as it was known at the time.

3. Avoid the part whole fallacy. There is more on this in the Chair and collab's book Practical Speculation.

4. Use non-parametric/robust statistics to avoid fat tail issues.

5. Simplify your studies to a very small number of variables.

6. Avoid looking at simultaneous relationships. They are descriptive and not tradeable. Instead concentrate on predictive relationships.

7. Avoid indexes, rather use prices that actually trade.

This list is only some of the pitfalls and traps to avoid in doing a proper quantitative study.

Newton Linchen writes:

It has happened more often than I would expect by chance that I found a pattern that was bullish or bearish with statistical significance, and the out of sample results were statistically significant in the opposite direction.

Isn't that annoying?

Doesn't it pushes us to the other side of the coin, of pure "tape reading", etc?



Here is a link to my favorite trading and investing books.



Unemployment Map of U.S-2007 TO 2010

Scary and Real!

Please review this Unemployment map of the United States. This is hard to believe, but TRUE! I had to review this map a couple of times to grasp the enormity of it. Watch the map automatically update from 2007 to 2010… WOW!

Nigel Davies comments:

The scary part may be the symbolic use of colors. Having black (death, nothingness, annihilation) for anything from 10-100% seems almost deliberately misleading and the map looks like a rotting piece of meat. There's probably a similar effect in chess, with players playing White often tending towards optimism whilst Black positions can have a look of doom about them. And you can deliberately magnify the effect by playing cramped looking defenses and even placing the pieces slightly towards the back of the squares. BTW, you get a similar psychological effect with candlesticks, the mind being subtly influenced to see down days (black candles) as being doom-laden whilst white ones appear to offer hope. A good practice may be to use green for down and a neutral gray for up, and maybe do something similar with one's Bollinger bands (black as the upper band, pink or something for the lower one). 

John Lamberg writes:

Many years ago, a wise professor taught me the visual power of choice of scale when preparing a X versus Y graph. 



Music and the instrument are not against the musician, and the instrument doesn't change (the keyboard order, for instance, doesn't change), so one can, with effort and time, master one's instrument. The markets are against us. And they change. And I don't think we can ever master them.



Once or twice each winter–during the boredom days, I bring up a puzzle from the basement game/storage locker. This season's is Claude Monet's "The Red Kerchief: Portrait of Mrs. Monet". I forgot where or when we got it. It was still in a wrapper with an art history store price tag. What great fun/interaction! I poured it out during a snowstorm day–enlarging the dining table with a few leaves. 500 pieces. And each piece seems to bring gladness. Time spent at the puzzle goes superfast. Kids walk past and then circle back and sit down to "work it"; wife loves to relax after dinner with the 'puz'. We are now 2/3rds done–each piece is a little victory–the shades of colors are illuminated by a task lamp on the table–"Monet can really blend"is what is heard by the casual commenter. I forget the market when I work the puzzle –thats a good thing sometimes, yes its a good thing indeed. I feel refreshed afterward—like a part of my mind has just been worked out.

James Sogi comments:

Speaking of winter pastimes, I recently tried a relatively new sport calledalpine touring. In Europe and Scandinavia they have done randonee andnordic touring for years, but recent advances in equipment have developedinto a whole new sport. The skis are semi wide skis. The special bindingsallow the heel to rise so a regular walking stride can be used while walkingover snow. Skins are attached to the skis to allow walking up steepmountains on skis on the surface of the snow. New advanced boots allowflexing cuffs that allow walking and climbing easily, but also lock down forcontroled skiing downhill through deep powder on steep couloirs at highspeed. This allows access to back country mountainous terrain in midwinter to enjoyfresh air, pristine uncrowded mountain landscapes. Alpine touring givesaccess to undeveloped terrain such as the Rockies, Alaska, Nepal, theHimalayas, Antarctica, Greenland. There are some amazing trips possible. The climb up is pleasant though hard work. The exertion puts the heart rateand breath right up against the cardio vascular wall and is a great workoutand a great endorphine high. The calories burn rate is close to 900calories per hour. The biggest thrill is the descent through deep power onsteep hills. Avalanches are a constant threat and can injure or kill. Three people werekilled last week in the Wasatch. The snow just healed two days ago fromprior storms when the snow crystals layers anneal. This healing processseems similar in many ways to current market consolidation.

Newton P. Linchen comments:

"I forget the market when I work the puzzle –thats a good thing sometimes, yes its a good thing indeed. I feel refreshed afterward—like a part of my mind has just been worked out."That's even most true about surfing. Your mind becomes "empty".Surfing, and many other sports/hobbies can put you into a meditative state - the one focused only in the task at hand - and that's indeed a relief for our minds.



Brain Basics: Brain Damaged Investor from Inside the Investor's Brain by Richard L. Peterson

According to a 2005 Wall Street Journal article, "Lessons from the Brain-Damaged Investor," brain-damaged traders may have an advantage in the markets (1). Study participants who had a brain lesion that eliminated their ability to emotionally "feel" were compared against "normals" in an investment game. The chief researcher, Professor Baba Shiv (now at Stanford University), used a mixed sample of patients with damage in emotional centers including either the orbitofrontal cortex, the amygdala, or the insula.

In Shiv's experiment, each participant was given $20 to start. Participants were told that they would be making 20 rounds of investment decisions. In each round, they could decide to "invest" or "not invest." If they chose not to invest then they kept their dollar and proceeded to the next round. If they chose to invest, then the experimenter would first take the dollar bill from their hand and then flip a coin in plain view. If the coin landed heads, then the subject lost the dollar, but if it were tails, then $2.50 was awarded. On each round, participants had to decide first whether to invest. The expected gain of each dollar "investment" was $1.25 (average of $0 and $2.50), while each "not invest" decision led to a guaranteed $1. The expected value of the gamble being higher, it was always the most rational choice. Thus, one might assume that subjects always "invested" in order to make more money.

In fact, the results are not uniform. Normals (without brain damage) invested in 57.6 percent of the total rounds, while brain-damaged subjects invested 83.7 percent of the time. Many normal subjects (42.4 percent) were "irrationally" avoiding the investment option. Following an investment loss in the prior round, 40.7 percent of the normals and 85.2 percent of the patients invested in the subsequent round. After recent losses, normals invested 27 percent less often. They became even more "irrationally risk avoidant" after a loss.

Of the patients with different brain lesions, the insula-lesion patients showed the leas sensitivity to risk, investing in 91.3 percent of all the rounds and in 96.8 percent of the rounds following a loss. As a result, it appears that the insula is one of the most important drivers of risk aversion. Without an insula, brain-damaged patients were more likely to "invest."

On the lighter side, neurologist Antoine Bechara ventured that investors must be like "functional psychopaths" to avoid emotional influences in the markets. These individuals are either much better at controlling their emotions or perhaps don't experience emotions with the same intensity as others. According to Professor Shiv, many CEOs and top lawyers might also share this trait: "Being less emotional can help you in certain situations." (2)

1. "Lessons from the Brain-Damaged Investor" Wall Street Journal, July 21, 2005.
2. Chang, H.K. 2005. "Emotions can Negatively Impact Investment Decisions" (September). Stanford GSB.

Newton Linchen replies:

Larry Williams teaches that we shouldn't try to "improve" our personality regarding trading and emotions. There are "emotional guys" and there are "cold guys". Being an emotional type and trying to become cooler is another problem to solve, and the markets gives us already much trouble to work with. So, he says in his books that we should only recognize "what type" of people we are, and develop our trading style accordingly.

Pitt T. Maner III comments:

With the availability of more and more powerful software programs for the average Joe, will the human element eventually be less of a factor? One for instance can play a very mean game of chess without being a grandmaster by using a powerful program to suggest moves. There are tournaments where this is allowed—man/computer chess. http://en.wikipedia.org/wiki/Advanced_Chess So could it be that there will be a move towards very advanced "cyborgian" arrangements in the future. Not necessarily more profitable but less emotional–more algorithmic. It seems the younger generations are more trusting of technology to solve all problems, and as costs come down on the technology and software, will there be a pull to use methods similar to those now employed by professionals? Can one become competitive by using a "crutch"? Mr. Schnytzer noted a couple of years ago, " My guess is that with Deep Blue at your disposal, you'll beat Nigel easily at chess, but won't improve on your options trading profitability." Of course there is a company, however, using the Cyborg name that promises (for a small fee) to bring all this to the common investor…but does it work, or with increasingly advanced software can it work in the future? http://www.businessinsider.com/cyborg-trading-promises-hft-solutions-for-joe-trader-2009-11

Kim Zussman comments:

'We should only recognize "what type" of people we are, and develop our trading style accordingly.' Up to and including not trading. The idea that anyone can learn to trade successfully can be checked by asking yourself: 

1. Could you learn to play competitively right now in the NBA , NFL, or national league?

2. How long could you stay conscious in the boxing ring for your weight class, or with an opponent twice your size (SEC says no guns allowed)?

3. If trading can be taught, why do most fail?

4. If a scientist, by definition shouldn't you be too quick to abandon convictions, and therefore vig-out with overly-tight stops?

Rocky Humbert responds:

The answer to Kim's question #1 and #2, as posed, is self-evident.But there may be flaws in the question. No one can just walk onto a field and play pro ball. Likewise, no one can walk into an operating room and perform open heart surgery. However, must people can (assuming they are able-bodied and mentally capable) invest thousands of hours and achieve some reasonable level of proficiency in most activities. A reasonable level of proficiency, does not mean being Derek Jeter, Tiger Woods, Christian Barnard, Buffett, Soros, Steinhardt and Robertson. Fortunately, one does not have to be in the 99.999999% percentile to be deemed a non-failure — or almost every reader (myself included) of this email would be over-dosing on anti-depressants! On #3, Why is there any reason to think that the percentage of traders who fail is any more than the percentage of entrepreneurs who fail (90%), or the number of people who drop out of the 36-week Navy SEAL class (70+%)? Competitive, high-risk activities always have a high drop-out rate. But, most of these people find their calling and are productive members of society…even if they can't throw a 100mph fast ball.

Jeff Watson comments:

I've often wondered where that meme of a 90% failure rate in trading originated. I see it in the literature, and hear it repeated all the time, accepted as gospel. Has anyone actually done a study to quantify this, or is the number just one of those numbers like Mitch Snyder pulled out when he quipped that "10,000 homeless people die a day".. And, what constitutes success in trading, what time parameter. Is success measured by return, by amount made, or by the ability of someone to grind out a small profit for 30-40 years, solidly in the black but never making a fortune?

Rocky Humbert replies:

Jeff's statement: "Is success measured by return, by amount made, or by the ability of someone to grind out a small profit for 30-40 years, solidly in the black but never making a fortune?" are great first questions. Regarding traders "failing," one should also consider a related data point: According to the BLS, the "average" baby boomer held 10.8 jobs from ages 18 to 42. 23 percent held 15+ jobs, and only 14% held fewer than 4 jobs. So, the "average" person changes jobs every 2 years. If one defines trading as a "job," then someone who does this, sitting in the same chair, for a long time is quite unusual compared with the population. see : http://www.bls.gov/nls/y79r22jobsbyedu.pdf

Kim Zussman comments:

No one can just walk onto a field and play pro ball. Likewise, no one can walk into an operating room and perform open heart surgery. However, must people can (assuming they are able-bodied and mentally capable) invest thousands of hours and achieve some reasonable level of proficiency in most activities.> My question is based on evidence like the article; supporting geneticaspects to behaviour, ability, gifts, and handicaps. Not everyone canbe trained to reasonable proficiency in the big leagues - and marketsare by definition among the biggest. Shouldn't traders ask themselves whether the reward/risk compensates the opportunity cost of thousands of hours of (potentially pointless)learning, if one may be (unknowingly) missing abilities needed toexceed results of buy and hold?

Peter C. Earle comments:

I am quite sure that this particular figure - 90%, sometimes shifted to 95%or even 99% - originated firmly in the late 1990s, when the SEC went afterthe SOES shops. They took, as their core example of the dangers, the exampleof one office of a particular firm which in a short amount of time morphedinto a general representation of the daytrading business (e.g., even the'prop shops' which were less focused on commissions than profitable trading)and was ultimately extended through word of mouth and the nascentblogosphere (e.g. message board jabbering) to cover any intraday tradingdone (online brokerage accounts, the occasional one day open/close, etc),and has since grasped the received wisdom of the collective mind at thispoint to an extent that it goes unquestioned. The fact is, the SOES traders/daytraders (as my man Lack will no doubtattest to) were mostly undercapitalized, out-of-work accountants andconstruction workers being sold 'maps to the gold mine', as it were. A better statistic, to start with, would be: with an $X account, after twelve months, how many remained?

Kim Zussman comments:

Interestingly, the author was as irrational as his subjects byfollowing the academic herd, making a low-risk, incorrect conclusion: "This study is especially relevant because of a concept called the"equity premium puzzle" that has long bemused financial experts. Theterm refers to the large number of individuals who prefer to invest inbonds rather than stocks, even though stocks have historicallyprovided a much higher rate of return. According to Shiv, there iswidespread evidence that when the stock market starts to decline,people shift their retirement savings—that is, their long-term, notshort-term, investments—from stocks to bonds. "Whereas all researchsuggests that, even after taking into account fluctuations in themarket, overall people are better off investing in stocks in the longterm," said Shiv. "Investors are not behaving in their own bestfinancial interest. Something is going on that can't be explainedlogically." This study, 2005, was in the middle of a decade where bondsout-performed stocks, and the irrationally risk-averse were punishedby missing out on ruin.



All you need to know in order to invest/trade in Brazil. Official document from BMFBOVESPA, the brazilian exchange. Nonresident investor guide (106 pages) [English]   (Discusses reqts. for registration with central bank, tax aspects, regulation, etc.) For more info see full list of Bovespa publications .



 Checklists have been shown to reduce errors, improve accuracy, and increase profits in many fields. Most recently, a study in the New England Journal by Atul Gawande shows that use of a 19 point check by surgeons could reduce deaths by 30% and save billions. Such simple things as knowing all the names of your colleagues and being sure that an adequate supply of blood and respiratory equipment is available are useful.

When it was suggested to me that a checklist for my own trading might be useful, I originally had the same reaction as the doctors. "I've flown with the eagles, climbed the highest mountain, captured the mountain lion, been a member of all the exchanges, played 12,000 refereed matches, went to Harvard." But then I read the reaction of the Drs. "I'm from Harvard. I don't need such a list. But if I was operated on, I'd like such a list."

Here's a list I came up with for the forgotten man, the hundreds of thousands of traders in stocks, futures and options.

Before the Trade

1. Do you know the name and numbers of all your counterparts, especially if your equipment breaks down?

2. When does your market close, especially on holidays?

3. Do you have all the equipment you'll need to make the trade, including pens, computers, notebooks, order slips, in the normal course and in the event of a breakdown?

4. Did you write down your trade and check it to see for example that you didn't enter 400 contracts instead of the four that you meant to trade?

5. Why did you get into the trade?

6. Did you do a workout?

7. Was it statistically significant taking into account multiple comparisons and lookbacks?

8. Is there a prospective relation between statistical significance and predictivity?

9. Did you consider everchanging cycles?

10. And if you deigned to do a workout the way all turf handicappers do, did you take into account the within-day variability of prices, especially how this might affect your margin and being stopped out by your broker?

11. If a trade is based on information, was the information known to others before you?

12. Was there enough time for the market to adjust to that information?

13. What's your entry and exit point?

14. Are you going to use market, limit or stop orders?

15. If you don't get a fill how far will you go? And what is your quantity if you get filled on all your limits?

16. How much vig will you be paying if you use market or limit orders and how does that affect the workouts you did knowing that if you use stops you are likely to get the worst price of the day and all your workouts will be worthless because they didn't take into account the changing price action when you use stops, to say nothing of everchanging cycles?

17. Are you sure your equipment is as good and as fast as the big firms that take out 100 million a day with equipment that takes into account the difference between being 100 yards away from an exchange and the time it takes the speed of light to reach you?

18. Are you going to exit at a time or based on a goal? And did you take into account what Jack Aubrey always did which is to have an escape route in case all else fails?

19. What important announcements are scheduled? and how does this affect when and what kind of order to use? For example, a limit before employment is likely to be down a percent or two in a second. Or else you won't get filled and you'll be chasing it all day.

20. Did you test how to change your size and types of orders based on announcements?

21. What's the money management on this trade?

22. Are you in over your head?

23. Did you consider the changing margin requirements when the market gets testy or the rules committee with a position against you increases the margins against you?

24. How will a decline in price affect your margin and did you take into account what will happen when you get stopped out because of margin?

25. What will happen if you need some money for living expense or family matters during the trade? Or if you have to buy a house or lend money to a friend?

During and After the Trade

1. What's your game plan if it goes against you and threatens your survival?

2. Will you be able to get out? Did you take that into account in your workout?

3. More typically, what will you do if it goes way against you and then meanders back to give you a breakeven? Or if it immediately goes for you or aginst you?

4. Would you be willing to take a ½% profit if you get it in the first 10 minutes?

5. Did you test whether taking small opportunistic profits turns a winning system into a bad one?

6. How will unexpected cardinal events affect you like the "regrettably," or the pre-annnouncement of something you expected for the next open? And what happens if you're trading an individual stock and the market goes up or down a few percent during the day, or what's the impact of a related move in oil or interest rates?

7. Are you sure that you have to monitor the trade during the day? If you're using stops, then you probably don't have to but then your position size would have to be reduced so much that your chances of a reasonable profit taking account of vig are close to zero. If you're using 10% of your capital on a trade, they you'll have to monitor it for survival. But, but, but. Are you sure you won't be called away by phone calls, or the others?

8. Are you at equilibrium in your personal life? You're not as talented as Tiger Woods, and you probably won't be able to handle distressed calls for money or leaks on the home front. Are you sure that if you're losing you won't get hit on the head with a 7-iron, or berated until you have to give up at the worst possible time?

9. After the trade did you learn anything from the trade?

10. Are you organized sufficiently to have a record of all your trades for your accounting and learning?

11. Should you modify your existing systems based on it?

12. How does recency and frequency and value affect your future?

13. Did you fit your after activities to your mojo?

14. If you made a good profit, did you take some capital out of the fray for a rainy day?

15. Have you learned to say "fair" whenevever anyone asks you how you're doing and are you sure that you don't spend a fortune after a good trade, and dissipate your profits with non-economic activities?

16. Is there a better use for your time than monitoring the ticks or the market every minute of the day if you do, and if you don't, do those who do so and have much faster and better equipment than you have an insurmountable advantage against you?

Well, specs, that's what I come up with off the top. How would you improve or augment it?

Nick White comments:

If a position begins moving against beyond what was anticipated in the workout can one, through either contacts or acquired counting skills, figure out as fast as possible why the move against is occurring? With that information, can one then discern whether or not such a move needs to be heeded, faded, or left alone?

What legitimate information sources can one leverage to better understand a particular trade? A buddy who is a floor trader, a mentor, a high ranking friend of a friend in a central bank?

Are one's current skills commensurate with one's trading goals and ideas? Perhaps, more importantly, are one's trading skills of the same league and caliber as those one is competing gainst in a particular market? If not, surely best to wait and keep capital safe until one is sure of one's edge. This strongly accords with Chair's admonition to never get in over one's head, and to not spend inordinate amounts of time watching each tick when that time could be more profitably invested in training and developing new and existing skills — counting, programming, etc.

Make the strongest effort possible to find out whether the tail wags the dog in a particular instrument that you're trading. If it turns out that it does, does it happen with significance at a particular time, such as expiry? Or after a particular event? Can it be exploited after costs or is it better to fade it after the fact?

If one asks these questions and takes note of them in the essential lab notebook that ought to be at one's fingertips during all trading and researching activities, have those questions subsequently been answered by oneself? I have found this to be the most fertile soil for developing new insights and ideas. If you observe it, note it and question it — hypothesize about it and answer it.

Alston Mabry comments:

Here's one: Don't fool/confuse/tire yourself by making your execution more precise than your analysis. If your target is 2% within the next five trading days, then chasing two bps on the entry isn't going to make or break the trade.

Easan Katir adds:

  1. If you trade odd hours, get enough sleep and appropriate caffeine dosage.
  2. One well-known S&P pit trader advised two bowel movements in the morning before setting foot on the floor.
  3. Start the day with a centering routine — affirmations and goals. Remind oneself of one's larger purpose.
  4. List important times and dates on an online calendar with appropriate alerts: government numbers, earnings, ex-dividend dates.
  5. Rehearse successful behaviors and outcomes. And disaster recovery.
  6. Minimize other life stressors: long commutes, family arguments, risky vices, debt.
  7. Test backup equipment and systems regularly. I test my diesel backup power generator weekly.

Victor Niederhoffer responds:

I would add a small point. Trading foreign markets always seems much more difficult than domestic ones. For one, you never know what the important announcements are. For two, you get killed on the spread on your foreign exchange prices. For three, it seems to be 100 times more time-consuming to get into the queue than even the 1/100 of a second that's enough to give the domestic high frequency traders an insurmountable edge on you. For four, you have to go without sleep for at least one night, and then on the second night when you can't stay up the required 48 hours without sleep the move you expected and closed out is sure to happen.

Alan Millhone writes:

Checker master Tom Wiswell said to always keep the draw (escape) in sight.

Scott Brooks adds:

I have to disagree with Easan on the caffeine. I know there are many people that have to have their morning cup(s) of coffee to get their day going, and without it, don't feel/function right.

I do not want to go through life being so dependent on something that I have to have it to make myself feel right, let alone function right. I know this will be anathema to most (everyone?) that reads this, but I have to say it.

When I removed the caffeine addiction from my life (and don't fool yourself, it is an addiction…..if you have to have it everyday and then quit it, you will go through withdrawals……it is an addiction), my life changed so much for the better. I can think clearly. I can process information more quickly, and I can see solutions with greater clarity.

And your sleep will improve immensely. I suffered from severe insomnia for years. Kicking caffeine out of my life has lead to my being able to fall asleep, usually within minutes and being able to get up earlier and feel more refreshed!

You will find a level of "mental processing" that you never thought possible when you replace coffee and caffeine with purified water (I drink around a gallon a day) and a glass or two day of the organic juice of your choice.

But be prepared, you will likely have around two weeks of headaches when you go through caffeine withdrawals (you know, from the caffeine that you're not addicted too).

Nick White agrees:

Ditching caffeine is a good move. Best to save it for when may really need it on an overnight (or two) session. As mentioned in the past, Dr. Shinya is fervently anti-caffeine. Like many others, I found Dr. Shinya's principles promoted many positive health benefits for my wife and me.

On that note, i find that the Shinya nutritional principles — when moderated by the ideas behind the paleo diet — are a real winner; the increased "good" protein from the Paleo program does much to mitigate weight gain from increased carbohydrate consumption when kicking off on the Shinya program. There is a Paleo program for those involved in elite endurance sports.

George Parkanyi writes:

On any project or major activity, the first question I ask is how much time I have. That frames everything that is to come.

The very next thing is to build a contact list with names, phone numbers (backup phone numbers) and email addresses (and account numbers and passwords). This is also true in Scouts, where we need to have that information at our fingertips for safety reasons — in fact for every camp we have to draft an emergency plan — police, hospitals, parents, primary first aid responsibilities, etc. In a trading operation this is critical. If you have key support resources who have to act on your behalf at a moment's notice, then they need to be available, you need to able to access them, and if not, there must be a ready backup contact and plan B, even C. Chair's point about having a pen available can even be a critical detail — what if, in the heat of battle, you have to write down, say, a wire transfer number? In my case, reading glasses would be another.

Kim Zussman comments:

As a periodontal surgeon, I have found it much easier to stay composed and rational during difficult surgery than unruly trades. Chair's excellent list hints at why, in the form of the question "how do you know?".

Surgical complications follow rules of biology, and mistakes usually come when overlooking something or miscalculating the compounded risk of several factors. One can and should practice with a large margin of safety, which in almost every case is easy to determine. Biology is almost immutable, but markets morph wildly in real-time. It is very difficult to stick with a position if you are honest about your cluelessness and unwilling to go down with the ship. When the trade goes bad:

1. What was your hypothesis? How many others had your idea too? Or the opposite one? Are they right? What do they know that you don't? What is the source of your confidence that you can out-smart (or out-run) the million-mind-march?

2. Did you test properly beforehand? Did you miss something; a signal from another market, a subtle backdrop to your traded market? What is the chance this time is different, and should this doubt change your mental stop?

3. How heavily is your market being manipulated? By government? Big banks? Goldman's trading desk? Does persistent manipulation / insider trading change your hypothesis or render hypothesis formation useless?

4. How do you know whether the move is merely noise of your correct hypothesis, or part of a regime change you have not noticed?

5. Deep and abiding doubt is essential to science, but how do you incorporate doubt into market prediction when most of the movement is random?

6. Does the non-linear, mostly random reward system of trading corrupt your judgment (sleep, personal life, etc)? Do some people lead a happy, well-rested life with long periods of gut-wrenching loss alternating with gain, and are you one of them?

7. What unalterable beliefs are necessary to trade successfully? If you hold them, are you sure they are the right ones? Should some beliefs be discarded as a result of a changing world? Are there new ones you should know, and are you confident you will see them when they develop?

Steve Ellison adds:

Margin of safety is a key concept in many fields. While skiing, I put on the brakes a bit earlier than I absolutely must so that if I miss my footing or hit a patch of ice, I have another chance to avoid the hazard (e.g., other skier, tree, out of control speed). Graham and Dodd wrote about margin of safety in investing. Rather than buy a stock that is below book value, a value investor might wait for an opportunity to buy a stock below 80% of book value.

If I ski 10 times a year, even on the same mountain I am likely to encounter 10 different sets of conditions — temperature, wind, length of time since last snowfall, etc. One day last year, the fog was so thick I could not see the trees on either side of the trail. Some conditions dictate caution; others are more forgiving and allow me to be more aggressive. A warmup run is an excellent way to get a feel for conditions.

Nigel Davies proposes:

Checklists are very good whilst learning, but I believe that one should ultimately aspire to be able to do without them because everything has been internalised. In my own field I tend to believe that conscious thought of any kind can be a distraction, which is why I don't like the old Blumenfeld Rule (a checklist used before playing a move).

Ken Drees writes:

I just did an experiment with my son with one of his Christmas presents, an electronic learning kit. We have learned so far the basics of how electricity works. Resistors (series and parallel), Capacitors, etc. Each lesson has a page explaining the experiment, a schematic, a drawing of the circuit in relationship to how water moves through pipes — the water analogy for electrical flow resonates with my son. And each experiment has an electronic "wiring checklist'.

The checklist comes in handy since its easy to forget a connection, misrun a wire, or leave an extra connection from a previous experiment in the lab circuit.

I associate checklists with "must have"–high accuracy functions. Like programming, wiring, piloting, fixing a car, cooking –its all routine, but items can be omitted, done wrong and can be forgotten due to human error. The checklist is a tool, an aide that removes ego from the scenario. Used in trading it helps set the trade up, helps initiate or close the trade, and removes emotion from what needs to be done automatically. A checklist in the grey area of a trade like the middle game in chess, or an operation where the patient is being worked on really doesn't help much–you need to make gut-inferred decisions, unless your trade is so automated that you remove yourself from the trade entirely and rely upon a program.

Using trading checklists help bring focus and energy towards the trading exercise. Using checklists of some sort during the "live–life of its own phase of the trade" must be explored further. Maybe there are ways to check off your decisions, check your options, use your skills with the pressure of time taken into consideration–during this live phase.

But when your hand is on a hot stove, trade going wrong, does one need to look at a post-it-note do determine if one should remove hand from stovetop?

FYI: a 9 year old boy is understanding electricity –public school may teach a child these ideas in 7th grade. I am amazed at what can be taught to children that most think is way over their heads.

Alan Millhone adds his two cents:

I will add my two cents. Some years ago I bought an International dump truck and it has air brakes. My late father and myself drove it for use in our construction projects. Because it has air brakes you need your class B driver's license to be legal. We drove it several years without the proper license. Finally my father got the book and studied and took the written part for class B. After he took that part he gave me the book and I studied and took the test and passed. Quite a book to study.

Now the second part was an over the road test with the instructor in the truck with each of us. He said he had never given a back to back test to a father and son. Dad and myself had to back the truck then drive to the right close as we could to an orange cone– without touching the cone. Then each of us had to do a 50 point check list of our truck that we earned (I still remember the list ) and still check my truck before taking it onto the road. So checklists are valuable in many applications ranging from dump trucks to the Market.

On a side note, dad and I rode to the test center in our dump truck without the proper license. The instructor said he was not going to ask how we got there.

David Brooks comments:

All very good ideas. I wish there were some good way to test Atul's theory historically. Why? Because I am convinced that poorer outcomes in the last decade come from fragmentation of the system - shift work, decreased work-hours by house staff, the high volume being forced through the system and de-professionalation of nurses.

Alas, we can't measure the past, but I am convinced that the hospital I started in (The Peter Bent Brigham of the early to mid 70's) was a safer, more humane place with better (allowing for technological changes) outcomes.

All the same, the reason we have embraced checklists a la airlines has to do more with the aeronautical outcomes than medical outcomes. The amount of information that a pilot has to process is order of magnitudes more than what a surgeon has to process. Furthermore, when a pilot fails completely 300 lives are lost, and when a surgeon completely fails, 1 life is lost. The former is far more dramatic, of course.

It's nice to know the anesthesiologist's and scrub tech's name, but it's hard to believe that that is going to affect the outcome of a significant number of operations.

That said, I have the greatest admiration for Atul. He sits a short distance from me, and I am proud to have had even a small role in training him. He is a remarkable young man and we will being hearing from him for many years to come.

Newton Linchen comments:

Once I took an airplane pilot course, and I was amazed how everything was done with checklists. Actually, the first time I heard the word 'checklist' was there. (Even here in Brazil they keep all the terminology in English, for standard procedure). I realized how checklists can keep you out of trouble and save your life. In markets, perhaps a great deal of losses could be avoided if I followed my own trading checklists.

Russ Sears writes:

Checklists can be very useful in an emergency. I have found that a simple checklist was valuable in a race. When the going gets tough it is easy to panic. The list It went something like this 1. relax 2. pump the arms smoothly 3. breath in normal rhythm (One hard puff out, relax in). It is easy to panic on the edge of your limits. These 3 things are the first signs that you are starting to panicking, subconsciously without knowing it.

Runner, use checklist often as part of their diary. Each day you check your weight, evaluate your nights sleep and your overall mental state. You check your diet and fluid intake .

Before a race you follow your pre-race checklist from what to pack, to when and what to eat, and when and how you should be warming-up and stretching.

Then after the race you check how well you followed the plan, where the plan worked and where if failed.

Finally at the end of the year you check the philosophical underpinnings of your training. Your goals, why you are doing it all, what are the cost that you are willing pay and what is the best path to get there.

So checklist have there place, but you need to 1. put them in the right point of time in the process, 2. not let them lose their relevance and meaning . 3. keep them simple at critical points, simple enough that they are potent.

Easan Katir adds:

Thinking about checklists, and watching the Haiti disaster coverage, made me think about a checklist for emergencies. Then thought about a list of the various types of emergencies one might encounter, big and small. What came to mind:






home invasion


mistaken id

false accusation






missing person


currency replacement/devaluation

market crash

partner deceit


power outage




i suppose each needs its own checklist, though some may overlap. What did I miss?

Scott Brooks adds:

The best checklist you can have is to either be a great leader or be around a great leader.

It's been my experience that average and ordinary people need checklists (which they rarely if ever have or use…which is one of the reasons why they are average and ordinary), but smart people with leadership skills don't need a checklist when it comes time for a disaster.

Most disasters/problems rarely follow a fixed pattern. It takes a leader who is capable of thinking on his/her feet who can stand up, take charge and direct people as to what they need to do.

And this doesn't have to be right all the time, he just needs to make decisions and get people moving and be willing to take responsibility and shrug of criticism of the naysayers…..while listening to them to extract the wisdom that might be contained in their "naying" (I think I have just made up a word).

A leader has to have insight and the ability to see several moves ahead. A leader has to be able to see correlations and connections between seemingly disparate pieces of information.

A leader has to then take this data and formulate a solution and then direct people to execute the solution….and if possible, get people to see the vision of the completed project so that they can begin to work towards that goal with minimal supervision.

But most importantly, a leader has to be willing to make a decision when it comes time to make a decision even when the solution is not apparent. A course of action that fails is better than inaction that is guaranteed to fail.



Gandhi said a person cannot be different from himself in different areas of his life. He meant a person really cannot be someone at work and a entirely different person at home, with his friends, etc. The personality is a whole –- you can’t have a mask for different occasions. What you do in private life echoes in your business life, and vice-versa. What you do in the different areas of your life (private, professional, friendship, religion, spirituality, fun) echoes in every other part.

If you are a fighter in your work, one cannot expect you to be a daisy flower at home -– you will treat your family with the same authority and discipline. If you are kind, you will be kind whether at home or at office. One cannot really perform different roles separately. The person is an unity.

That means if you are lazy, undisciplined, late, in your behavior, it will reflect in your trading. Have you ever thought your trading problems may not be trading related? If you find yourself…

1. Unprepared
2. Getting late
3. Not aware of details
4. Leaving office or desk at crucial times
5. Answering phone calls at trading time
6. Talking aloud as if your office was a party
7. Not taking care of your trading journal…

Can you honestly say that the problem is with the market?

Marion Dreyfus comments:

Not sure about this. Some children are quiet at home, noisy at school. Many of us are introspective at work, but different at private functions. I know people behave differently all the time…

Newton Linchen responds:

I didn't mean surface behavior. An example of what I meant is that person who cannot endure "suffering" (such as boring parametrization) to achieve results. In this matter, Daniel Goleman mentioned a study of children who could not wait the experiment time to not eat a cookie in order to get two cookies — and it seems this behavior (of immediate gratification) had an impact in their professional lives.

Marion Dreyfus comments:

Ahh, yes. Literalist me.



Cachaça"Trading is fun", I hear once in a while. It's a "cachacinha" ("Cachaça" is a Brazilian alcohol beverage made from sugar cane). They mean, trading is addictive. From "fun" to "addiction" it takes only a small step.

I was once addicted to trading. My account suffered. It took a LOOOOOONNNNNGGGG time to free myself from the addictive power of the markets. Now I'm making money, for me and for my clients. Guess what? The fun is gone. The fun is completely gone, for I'm using a method to improve profitability and reduce overtrading (overtrading leads to poorer performance), and, as a side effect - and what effect! - the emotions of trading are gone.

Whoever you talk about trading, they will tell you amazing epic stories about great bravery, suffering and battle. They include all emotions: fear, greed, joy, pain, etc.

Few, very few people will tell you that trading is boring, just like factory work. Guess what? The emotional traders are not making money. The boredom traders are taking money from them!

What is boring about trading? To be honest, to quantify is boring. It takes time. It takes effort. It takes more time. And it takes more effort. So it is to parameterize. To test is boring. To avoid spurious correlations is boring. To avoid anedoctal evidence is boring. To do the same trades over and over and over is boring. To not deviate from the plan is boring - specially when your gut feeling makes an extraordinary call about the markets. All that is boring. Boring. Boring. Boring. Boring.


It makes you money. Trading is such an interesting field that one cannot get FUN and MONEY at the same time.


Nigel Davies comments:

The acid test may be if someone stops trading, will he miss it? Chess stopped being fun for me a very long time ago, but when I don't play something is missing. Some colleagues who've given up say this goes away after a while, others keep playing their whole lives. The progression seems analogous to being in love, being married and breaking up.

Nick White responds:

I don't know — I think trading can be enormously fun. I think what Newton is really driving at here is the difference between process and outcome and the balance of emphasis between the two in different groups of traders.

I would argue that process-driven traders spend much more time doing "dull" activities like researching, programming, quantifying, testing etc. Furthermore, I would say that traders involved in these process-driven activities do so because they genuinely enjoy being in the market, love the challenge / intellectual stimulus of trading and are committed to learning as much as they can.

Focusing on process grounds the trader - if the trader gets it wrong, she has a foundation to revisit her thesis, look at the data and learn from her mistakes. If a trader is doing well and trading at his high watermark, a process-driven focus helps him fight hubris. The NYT article about Shane Battier had it exactly right - process driven performers don't measure themselves explicitly by whether they won or lost on a particular trade - they measure themselves on whether they did the right thing at the right time given the information they had. So, net-net, process-driven traders are likely to enjoy the activity of trading irrespective of the final result: they like the research, they fight for their edge and they play it. If they win, so much the better. If they lose, it still sucks, but they can put that loss in perspective…the kicker being that enjoyment of process-driven activities gives a much higher likelihood of getting positive outcomes in the first place.

On the other hand, outcome-driven traders seem to want the high of good pl without the necessary work to ensure non-random results. They seem to trade to prove something either to themselves or others. I'm sure Dr. Steenbarger and Dr. Dorn would be able to contribute much on this point but, from my amateur armchair, I would say that traders driven by outcome aren't really into trading because they like it, but are into trading as a proxy for some other need they are trying to fulfill. In that sense, trading probably is addictive for much of the same reasons that any activity or substance can become addictive - it likely helps to reinforce desired feelings and self-image while shunning unwanted ones.

In short then: if you trade because you love it and like doing the research work for its own sake, then you are more than likely going to enjoy trading irrespective of the final result - but you also have a greatly increased chance of success. Trade to "be" something / somebody and you are likely to come unstuck quite quickly. (All this is said with the caveat that these two camps aren't neatly delineated, but seem to be something of a spectrum, with all of us lying somewhere on the line at different stages of our careers.)

Process can be dull; no doubt about that. But, as an old coach once told me, "what you can't do in training, you won't do in racing". If you haven't spent the time to quantify, test, understand and introspect about how you would approach your chosen market in a given situation, you won't know how to respond when it happens for real. It is one's emphasis on process / outcome that determines whether results are a statement about one's self, or are simply indications of progress on the path to improvement.

Philip J. McDonnell remarks:

One of the trading mottoes I live by is:

If trading ever gets exciting I am probably doing something very wrong.

The underlying logic is that losing is what makes trading exciting. Think about a savings account. It always wins and is very boring. It is boring because it wins. The losses appeal to us emotionally. They create the nor-adrenaline rush. It is too easy to get addicted to the rush. The adrenalin driven figt or flight mode satisfies us emotionally but numbs the mind. Slow and steady is better and frees the mind to think logically.

Newton P. Linchen replies:

Phil just nailed it!



In journalism, the Five Ws (and one H) are: WHO? WHAT? WHEN? WHERE? WHY? HOW?

The very questions a trader must answer in order to be profitable! “WHO?” is about the asset class or trading vehicle. “WHAT” is about the move. “WHEN” is about timing. “WHERE?” is, quite obvious, about the exchange - but can be less obvious if you mean exchange access (desk order, home broker or DMA?). “WHY?” is the source of the move, the reason behind it. And, finally, “HOW?” is the way it play itself (volatile or not? sudden or not?, etc). It’s clear to me that the work of a trader is very related to the work of a journalist. One difference: the trader has to answer the above questions BEFORE the events take place.



SwanIn my limited experience, risks such as the "Black Swan" type are unusual. Most of the risk we newbie traders assume are not real risks — only mismanagement of risk. One of the most common is "impulse trading" (i.e., trading without an edge or overtrading).

Well, last week I had a lesson on Impulse Trading. I was driving with my family (wife, kid and the nanny) to the border of our state and country — Jaguarão, a city on the border of Uruguay — to do some shopping at the free market shops.  The travel couldn't be by plane (there's no airport there), so we went on a 5+ hour driving trip.

You know, my boy is almost 3 months now — and he is my first son. So I was driving in a long (for me) journey with my boy in the car. There were moments where one, two or three trucks were  blocking  the road, and of course, I wanted to pass them. Another time, I would risk every chance to pass them. But now I had my kid in the car so I only took the completely free-risk shots. There was nothing in  the world that would made me risk my boy's life in brave and daring driving. No way!

Immediately I felt ashamed of the times I took trades that were not "high Sharpe situations". How could I be so risk-idiot? For a person not money-centered (which I believe I am not) trading is the most difficult challenge. Because it's so easy to mismanage risk. "Oh, it's just another losing trade - no big deal". It is a big deal!

If I approach trading with the notion that my wife and kid are in the car, I will become the most aggressive risk manager. And they are: the money that is lost is the money they will not enjoy — and, G_d forbid, money that they will lack.

So, from now on, my wife and kid are in the car on every trade!

Scott Brook reacts:

Black Swans may be rare, but they are game-enders.

That's why you should never go "all in" when playing poker. I get derided all the time for saying this, but I made a lot of money playing poker back in the 80s using this strategy. Of course, that was in the days when you could play stud poker and not this "Texas Hold'em" crock that they play today. In today's MTV fast paced, leverage to the hilt world, you have to go all in to compete. Otherwise, people aren't interested in doing business. They want the big returns and they want them now, "D%mn the torpedo's, full speed ahead!"

You could call me a grinder. I always found a way to grind out a winning night playing poker. Sure I was boring, and yes, I was still subjected to the occasional black swan, but even after the swan wreaked havoc on me, I might have been wounded, but I was still standing and able to play the game.

P.S.: I've also traveled cross country with small children. I found it to be a less than pleasant experience. That's a black swan I would like to avoid for the rest of my days!

J. P. Highland adds:

1. Poker is a great trading boot camp. Folding is the hardest part to master, learning that second rate hands usually finish second.

2. In trading you have two opponents, one is Mr. Market and the other one yourself. The second is a tougher SOB to manage.

Steve Leslie writes:

Tournament poker and cash poker are two distinct animals. They are entirely unrelated and require different skills. WSOP main event is no-limit hold-em which for years was a very small event. Look at the event fields up to 2002 — they were quite small. When Johnny Chan won his first title I think fewer than 50 people were involved. All that changed when Chris Moneymaker won. Also the big game players like Greenstein, Reese, didn't even play tournament poker. TV and the Internet changed all that. Now last year's winner was under 24 and beat Phil Hellmuth's record set back in 1987. Their techniques comsist mainly of bluffing and hyper aggression. Most crash and burn early but there are so many of them like ants that it is impossible to kill them early so some make it to the latter stages. Mr. Brooks and I are anachronisms. Try to find a seven card stud game or draw poker. They don't exist anymore. Nobody knows how to play them. Even Omaha is difficult to find. In the Cincinatti Kid they played five card stud. When I played poker in the 1990s they were closing up card rooms. All that is left today is no-limit hold-em cash and no-limit hold-em tournament. Finally, the skills you can learn from poker are transferrable to trading on many levels. Others have written exhaustively on this. I strongly suggest two books: Zen and the Art of Poker by Phillips, and Zen in the Martial Arts by Hyams. Start there.



N LinchenInvited by my sister, I took today my first tennis class. Some market lessons came right away from the court.

Keep your eye in the ball - I know, I know, this is an oldie. But goodie: I never had to really keep my eye on a ball before. Now I understand those times when the market made a move against my position while I was at lunch, or with my eyes on something else.

Don't try to impress anyone - You know, I'm older than my sister and she is very competitive. It just doesn't work trying to impress someone when you are performing. (Don't mention the lack of preparation!) - It reminds me trying to manage money for friends, or, worse yet, for my mother-in-law.

Beware the impossible ball - Do you have to go for that impossible ball? Here I took my first landing on the sand (yes, I felt it) and my first bruise for trying to reach something I wasn't prepared to at the moment. (How many times we just shouldn't trade considering wild market conditions?)

Tennis is fun. - The 1 hour class took 10 minutes in my mind. Yes, tennis is fun. And so is trading. Beware: In tennis one has fun, and loses weight, fat, and the exercise is good for the heart, etc. In trading, when one is having fun, he loses money, money, more money - and that's NOT good for the heart.

If you keep up the practice (they told me) you can attain good results. - In trading, only practice, study, research, more practice, more study, more research can deliver good results with time.

Everyone can play tennis, but not everyone can master tennis and make a living from it. - In the markets, everyone can call his/her broker and shout "Buy! Sell!", or at least type the correct numbers and codes into the home broker on the internet to buy and sell. -But not everyone can make a living from it.

You need proper equipment. - One of the causes of my "accident" (kissing the court's sand) was because my shoes weren't "tennis shoes". So they performed badly under an important circumstance - I was running for that impossible ball. - In trading, proper equipment may be considered an edge as it gives you information first and allows you to trade quickly.

I think the next classes will bring more insights. But, if I only had tonight's class before I made any trade or investment in my life, my own results would be a lot different!



C MI've been thinking about whether there's a correlation between trading success and intelligence. Do people with high IQs do better at the trading game than those with low IQs? I wonder if high intelligence is a prerequisite for trading success, or if it even fits into the equation.

Are traders in some markets smarter than those in other markets? Are the index or currency guys smarter than the grain crowd, for instance? Are the upstairs guys smarter than the floor guys? Does higher education really matter, or even have a correlation with trading success? Has any of this ever been measured before? An interesting thing to ponder is if there might be a correlation between juvenile behavior and trading success. Perhaps the most important traits for traders are balance, emotional intelligence, the ability and discipline to execute a plan successfully, and courage. Some of the smartest people I've ever known have been really bad traders, whereas I've known very successful ones who don't exhibit outward signs of extra intelligence.

Newton Linchen adds:

This is a great issue. How many times we sit and shout "why oh why didn't I trade the way I said (plan)?" This happens despite our intelligence — one thing is to be able to "understand" or predict markets — other is to be able to translate this view into action. Perhaps the best strategist is not the best fighter — and it's very unusual to see a strategist-fighter or fighter-strategist.

Generals plan their moves at night, in the tents, but they send the soldiers to do the job the next day.

GM Nigel Davies replies:

Even in a supposedly intellectual game like chess, character plays a much larger part than intelligence. A major part of it is in whether someone can bring himself to falsify his ideas or instead uses what intelligence he has to justify them.

Steve Ellison observes:

I suspect that practical intelligence (synonyms: business savvy, street smarts) is more important to trading success than the type of intelligence measured by IQ. Ben Green, in the preface to Horse Tradin', noted that horse dealers had to know about many factors such as demand, climate, crops, and soils, but then went on to say:

For a big dealer in a central market to be successful he also had to acquire a keen understanding of human nature… None of the knowledge needed by a high-class horse and mule dealer could be learned from books or schools, and it would be well understood that these men were usually middle age or over.

Last but not least, he had to be a man with a lot of nerve, who was willing to back his own judgment and that of his buyers and to face the risks involved in shipping, loading, and unloading (together with the possibility of various shipping diseases) that were a hazard of the business… It is easy to see that with money going out in both directions it took larger amounts of capital, accompanied by a good nerve and judgment, to be a successful central market dealer.



 Bernardo Bonamigo Linchen is the newest trader in the pit. He knows perfectly well how to get milk through the old "open outcry" system. His father is just the clerk and his mother is the milk clearing house…

He was born yesterday, 3:14 P.M., but only today I got the time to take a photo as the tradition of Daily Speculations commands. We are reading Victor Niederhoffer and Larry Williams…

I'll be busy for some time, now… Anyone interested in helping in the night shift?



 In the bargaining process one side has the advantage. At some point that advantage switches to the other side, often, but not always, on consummation of the deal. Take a simple market purchase in which bargaining for price is involved. The customer in most sales has the advantage at the beginning since he has the money and the seller needs to sell a product with limited shelf life along with a number of other sellers of similar products. The buyer can negotiate a lower price during the typical three rounds of back and forth. The original offer or bid will set a range that slowly narrows until a deal is reached. The buyer has an advantage of being able to set the range, the initial offer, and he has the money. Once the money changes hands the seller instantly has the advantage, as the goods may not have been what they appeared. In money changing, sleights of hand can often make a deal less than it seemed. In legal matters, at times the first offer has the disadvantage. Now in a real estate market, buyers have the advantage.

In looking at the electronic markets, it is clear that one side has an advantage at times. The timing of this is important. In a dropping market, (define that as you may), bids clearly have the advantage. They have the money, they can submit lower bids. Their advantage lasts until the bottom tick or until the buy fills. The buyer then is at a short term disadvantage until the bottom tick at which point advantage goes to buyer holding in a rising market. At some point after the market turns, the buyers want in, and start competing with each other and raising bids. The buyer holding in as rising market has the best advantage to a point, i.e top tick. The seller, holding wanted goods, has the advantage and can keep raising the offers. As soon as the seller has sold his goods his advantage ends, unless he got top tick. If the seller waits too long and the bid disappears, his advantage disappears as well. The short seller has even less advantage since he owes his creditor as well.

Jeff Watson writes:

In the old days of open outcry, one could easily manipulate the bids and offers by goosing the market. If a buy order came into the market, (and one could detect whether it was a buy or sell order by looking at the movement of the broker's eyes) one could start bidding up a quarter in front of the broker, and perhaps get him to raise his bid where you could in turn sell it to him. One could do the same thing on the sell side. Although this was an effective method for extracting a little extra cash out of the market, it was fraught with danger, since you could easily get speared and end up being long or short a few contracts that you didn't want. Getting speared happened every day and was just the cost of doing business.

Newton Linchen replies:

I was reading the history of the Bovespa (brazilian main stock exchange), and I read that there was a guy who used to hit the market with a big buy or sell order and then hide in the toilet in order to not get filled! (He used to "mess up" this way until he was caught). Your description of reading the eyes of the broker in order to know whether it was a buy or sell order reminds me the tales of the Samurais, where they stood one in front of the other reading each other's breath. The strike always used to come when the opponent was finishing his exhale — the moment he was weaker.



 Trading is toil.

Victor mentioned once: "I never have fun trading. It is too serious".

Trading is toil, especially because it's already hard work in the first place to find a model, a "setup", a strategy that actually works, but then you must adapt it, which is the very hardest part. Once you have a "love" (something that makes your trading profitable), whether it is a strategy, model, parameter, or setup, it becomes very painful to watch your love fade and die.

I know we shouldn't personalize trading, but the fact is we (or I) develop an emotional relationship to our precious tools — every time I come across something worthwhile, after much toil, I feel so glad. I feel a sense of work well done. It's a very pleasant feeling. And I cannot refrain from emotional pain when a market relationship I was profitably trading becomes weaker and eventually non-existent.

To adapt,  one must have the emotional strength to, after much toil, model a strategy, and say to yourself: "you may have no value in the future."

Trading is strange, because it demands skills one would probably not wish to nurture if it wasn't necessary.

Trading is a stoic school.

George Parkanyi adds:

The shorter the time frame, the more frenetic, temporal, and tiring will be any form of discretionary trading. And the greater the need to predict, the greater the effort required as well. You can economize your efforts by researching and planning interim position trades or even multi-year trades, and then letting the positions play out while you comfortably research others. You can also economize by trading statistically –- researching an edge and then mechanically following the methodology you use to exploit it (this is more like a business). Or ultimately you can eliminate the need to predict altogether. You can simply use a passive re-allocation strategy or some kind of averaging approach and let the market sort things out over time.

The sense of toil comes from the feeling of the need to be right, either emotionally and/or financially -– and the market unfortunately is completely insensitive –- nay, gleefully contrary some would say, to that. You will be wrong many times, more so the more active you are, and will have to come to terms with it.

The markets supply a tremendous amount of energy in their own right. If you think of the market as an opponent, as in judo, think about how to use the market’s own strength against it, and to conserve your own.

Newton Linchen replies:

 Great point. I actually practice Aikido, which is a martial art similar to Judo, but with more emphasis on letting the opponent defeat himself.

I'd rather not think of the markets as someone, or as an opponent, since I would have to picture "him" 100 feet high and with enormous muscles. (It would certainly come after me in my nightmares!)

I prefer to think of the market as a force of nature, such as water, fire, or whatever. You can develop a safe approach to it, and make it the heart of a nice hot tub or bath, or get drowned or burned.

And to put together a bath tub is toil, at least for me!



Is there a form for the typical market? Does it have a shape, a proper way of conducting itself? Is the form for a week regular enough to defy randomness or better yet to be predictive in any way? Is there a form corresponding to the a b a form of music in markets? How does rhythm and volume of sound enter into the picture? Those are the questions I'm pondering this after reading a great book on the walking bass by Jon Burr.

Thomas Miller writes:

I have always believed the markets are similar to musical pieces. A rhythmic sideways market lulls many into relaxed state only to burst higher or lower in mighty sudden crescendos, and a rallying or declining market moves in musical waves with mini crescendos noting momentary tops or bottoms. I wonder how many successful traders have musical backgrounds? Music and mathematics are universal languages and convey the messages of markets. I regret not having more formal training in either.

Newton Linchen replies:

I always thought "Metamorphosis IV" by Philip Glass to be the perfect "market music", not only by its crescendos and decrescendos, but by its impression of regularity (Philip Glass is known as the father of "repetitive music"). Nevertheless, its changes in tempo and volume (strength) gives a rhythm almost fluid. And there's a part of "explosion" (volatility) where the fast-pace is in order — without loss in harmony or structure. I always thought of moments of "trading range" of market going aimlessly followed by a explosion in price upwards or downwards. And it's kind of sad melody remembers us of the majority who only find losses in the markets.

James Lackey comments:

Yeah it's been brutal awful market music. Reminds me of all the VIP mumbo parades, changes of command formations, and dress blue parties I was forced to attend in the Army.

0300 with the Dax open its reveille. Then we all form up into one huge cluster in the parade grounds stand for an hour then "the stars and stripes forever" plays with a government official on the mic saying how far we have come our history and how they are committed to Change "us" with too many last hour's "retreat."

Then with so many brutal last hours "to the colors" reminds me of Flag detail after the close then the discussions with old Colonels passed over, that didn't want to go home to family asking "the kids" new soldiers over a 5pm coffee what we wanted to do with our lives "when I was your age and if I could do it all over" then every few nights after Chow we get "Washington post march" the tune used most in movies to sound off patriotism and how if we all work together, after the next bailout everything will be back to the normal American way… Then back at 7pm "Auld Lang song" to the Nikkei open.

I have noticed over the years my music tastes intra day trading go with the market flows, Baroque, Jazz, Fusion, and when the market is rockin', new alternative rock.

I am in a bad way when all music sounds awful, like Army band music. I would rather listen to the hum of the ceiling fan and as of late the birds singing to the open windows..and to my surprise, spring has sprung and a lawnmower engine sounds more inviting than the music of the markets. ha.

The U.S. Army Band Ceremonial Music Guide

Legacy Daily responds:

 When the Soviet Union collapsed, I witnessed the creation of foreign exchange markets and also of stock and other types of markets in Armenia. These images are very vivid in my mind. When I read about people trading on Wall Street (I mean before the exchange building was even a consideration), I can see how that trade took place, because I participated in similar trades in a few of the streets of Yerevan (different places of gathering for different markets). That experience always overrules the charts, the derived statistics, the counts, and all the jargon that I hear daily.

Does the market have a form, a proper way of conducting itself? This question brings up the picture of the crowd dealing in foreign exchange (with the usual guys leaning against their usual trees) against the typical crowd dealing in real estate or stocks or stamps or coins. Of course each market has its form, its unique characteristics, its shape, its place, its rules. Each market has its rhythm, its language. I have not had the opportunity (and never really wanted) to participate in the floor trade at the NYSE or in the outcry system. But having seen the seedlings in their early stages of germination, I only see supply and demand and the various factors that affect these.

In this digital age, it is easy for one to go long bonds and short stocks or long XOM short CVX without ever realizing that the market for every single security represents a unique gathering of those who run the market and those come to the market. If I had to put this picture into something related to music, I'd imagine a choir of professional singers that sing a particular song we recognize. At some point, we join in singing in our heads and then at one point begin to sing out loud thereby changing the overall experience of everyone around us until we move on to the next choir singing a different song. Could one be successful in singing with multiple choirs all at the same time? Can we really understand the market for the SDS and SPY which are derived from hundreds of unique markets with their tunes in addition to their own market creating noise at the same time? What about the noise from the "gold" room affecting the singing going on in the "dollar" room or the other way around?

When it comes to commodity markets, I remember the fruit and vegetable market where some of the sellers would sell what they had grown and the others would sell what they had bought from those who couldn't or didn't want to travel to the market. Does that have a music? If you have ever been in a similar market, you'd recognize the buzz, the "singing" of the man selling his delicious watermelon, and the aroma coming from the area where peaches are sold.

The big question - is all this random or is it predictable? There is nothing random to it, yet it is completely unpredictable. The market makers operate in a very normal expected way, yet those who come to the market act in ways I cannot anticipate or predict. The only elements visible are my own instincts, wishes and desires which happen to approximate those of the people who go to the market very well. Imagine you have a phone to your ear that is connected to a line on a speakerphone where hundreds of people are talking at the same time. What do you hear? Noise! Can you find patterns and conversations in the noise, in some cases yes. Are the conversations and patterns going to repeat? In some cases, absolutely ("How are you today?" is typically followed by "I'm well thank you." or some variation of that) I'd like to be convinced that they could be consistently reliable but then again if that was feasible someone would have already found a way and would have proudly advertised that "past performance does not guarantee future results" does not apply to them.

Jim Sogi writes:

One constant regularity of form in music is the return to the root or home base. I think the market tends to have a root or home for each of its pieces. Recent root seems to be 800. Prior jump on Fed had to return Treasury plan to resolve. 800 was a big theme earlier in the year as well. Now we are in the contrapuntal mode, as Bach would play it doing it from the reverse. In a larger sense, it all satisfies the craving for symmetry and resolution.

Often the craving is frustrated creating a tension. Music is all about emotions on different levels, as is the market. Musical gaps are one of the greatest sources of tension. We still have this Monday gap right below created by maestro Timmy G and the trillion dollar blues. Too much tension and disruption of rhythm to make good music.



CurveHow can we avoid curve fitting when designing a trading strategy? Are there any solid parameters one can use as guide? It seems very easy to adjust the trading signals to the data. This leads to a perfect backtested system - and a tomorrow's crash. What is the line that tells apart perfect trading strategy optimization from curve fitting? The worry is to arrive to a model that explains everything and predicts nothing. (And a further question: What is the NATURE of the predictive value of a system? What - philosophically speaking - confer to a model it's ability to predict future market behavior?)

James Sogi writes:

KISS. Keep parameters simple and robust.

Newton Linchen replies:

You have to agree that it's easier said than done. There is always the desire to "improve" results, to avoid drawdown, to boost profitability…

Is there a "wise speculator's" to-do list on, for example, how many parameters does a system requires/accepts (can handle)?

Nigel Davies offers:

Here's an offbeat view:

Curve fitting isn't the only problem, there's also the issue of whether one takes into account contrary evidence. And there will usually be some kind of contrary evidence, unless and until a feeding frenzy occurs (i.e a segment of market participants start to lose their heads).

So for me the whole thing boils down to inner mental balance and harmony - when someone is under stress or has certain personality issues, they're going to find a way to fit some curves somehow. On the other those who are relaxed (even when the external situation is very difficult) and have stable characters will tend towards objectivity even in the most trying circumstances.

I think this way of seeing things provides a couple of important insights: a) True non randomness will tend to occur when most market participants are highly emotional. b) A good way to avoid curve fitting is to work on someone's ability to withstand stress - if they want to improve they should try green vegetables, good water and maybe some form of yoga, meditation or martial art (tai chi and yiquan are certainly good).

Newton Linchen replies:

The word that I found most important in your e-mail was "objectivity".

I kind of agree with the rest, but, I'm referring most to the curve fitting while developing trading ideas, not when trading them. That's why a scale to measure curve fitting (if it was possible at all) is in order: from what point curve fitting enters the modeling data process?

And, what would be the chess player point of view in this issue?

Nigel Davies replies:

Well what we chess players do is essentially try to destroy our own ideas because if we don't then our opponents will. In the midst of this process 'hope' is the enemy, and unless you're on top of your game he can appear in all sorts of situations. And this despite our best intentions.

Markets don't function in the same way as chess opponents; they act more as a mirror for our own flaws (mainly hope) rather than a malevolent force that's there to do you in. So the requirement to falsify doesn't seem quite so urgent, especially when one is winning game with a particular 'system'.

Out of sample testing can help simulate the process of falsification but not with the same level of paranoia, and also what's built into it is an assumption that the effect is stable.

This brings me to the other difference between chess and markets; the former offers a stable platform on which to experiment and test ones ideas, the latter only has moments of stability. How long will they last? Who knows. But I suspect that subliminal knowledge about the out of sample data may play a part in system construction, not to mention the fact that other people may be doing the same kind of thing and thus competing for the entrees.

An interesting experiment might be to see how the real time application of a system compares to the out of sample test. I hypothesize that it will be worse, much worse.

Kim Zussman adds:

Markets demonstrate repeating patterns over irregularly spaced intervals. It's one thing to find those patterns in the current regime, but how to determine when your precious pattern has failed vs. simply statistical noise?

The answers given here before include money-management and control analysis.

But if you manage your money so carefully as to not go bust when the patterns do, on the whole can you make money (beyond, say, B/H, net of vig, opportunity cost, day job)?

If control analysis and similar quantitative methods work, why aren't engineers rich? (OK some are, but more lawyers are and they don't understand this stuff)

The point will be made that systematic approaches fail, because all patterns get uncovered and you need to be alert to this, and adapt faster and bolder than other agents competing for mating rights. Which should result in certain runners at the top of the distribution (of smarts, guts, determination, etc) far out-distancing the pack.

And it seems there are such, in the infinitesimally small proportion predicted by the curve.

That is curve fitting.

Legacy Daily observes:

"I hypothesize that it will be worse, much worse." If it was so easy, I doubt this discussion would be taking place.

I think human judgment (+ the emotional balance Nigel mentions) are the elements that make multiple regression statistical analysis work. I am skeptical that past price history of a security can predict its future price action but not as skeptical that past relationships between multiple correlated markets (variables) can hold true in the future. The number of independent variables that you use to explain your dependent variable, which variables to choose, how to lag them, and interpretation of the result (why are the numbers saying what they are saying and the historical version of the same) among other decisions are based on so many human decisions that I doubt any system can accurately perpetually predict anything. Even if it could, the force (impact) of the system itself would skew the results rendering the original analysis, premises, and decisions invalid. I have heard of "learning" systems but I haven't had an opportunity to experiment with a model that is able to choose independent variables as the cycles change.

The system has two advantages over us the humans. It takes emotion out of the picture and it can perform many computations quickly. If one gives it any more credit than that, one learns some painful lessons sooner or later. The solution many people implement is "money management" techniques to cut losses short and let the winners take care of themselves (which again are based on judgment). I am sure there are studies out there that try to determine the impact of quantitative models on the markets. Perhaps fading those models by a contra model may yield more positive (dare I say predictable) results…

One last comment, check out how a system generates random numbers (if haven't already looked into this). While the number appears random to us, it is anything but random, unless the generator is based on external random phenomena.

Bill Rafter adds:

Research to identify a universal truth to be used going either forward or backward (out of sample or in-sample) is not curvefitting. An example of that might be the implications of higher levels of implied volatility to future asset price levels.

Research of past data to identify a specific value to be used going forward (out of sample) is not curvefitting, but used backward (in-sample) is curvefitting. If you think of the latter as look-ahead bias it becomes a little more clear. Optimization would clearly count as curvefitting.

Sometimes (usually because of insufficient history) you have no ability to divide your data into two tranches – one for identifying values and the second for testing. In such a case you had best limit your research to identifying universal truths rather than specific values.

Scott Brooks comments:

If the past is not a good measure of today and we only use the present data, then isn't that really just short term trend following? As has been said on this list many times, trend following works great until it doesn't. Therefore, using today's data doesn't really work either.

Phil McDonnell comments:

Curve fitting is one of those things market researchers try NOT to do. But as Mr. Linchen suggests, it is difficult to know when we are approaching the slippery slope of curve fitting. What is curve fitting and what is wrong with it?

A simple example of curve fitting may help. Suppose we had two variables that could not possibly have any predictive value. Call them x1 and x2. They are random numbers. Then let's use them to 'predict' two days worth of market changes m. We have the following table:

m x1 x2
+4 2 1
+20 8 6

Can our random numbers predict the market with a model like this? In fact they can. We know this because we can set up 2 simultaneous equations in two unknowns and solve it. The basic equation is:

m = a * x1 + b * x2

The solution is a = 1 and b = 2. You can check this by back substituting. Multiply x1 by 1 and add two times x2 and each time it appears to give you a correct answer for m. The reason is that it is almost always possible (*) to solve two equations in two unknowns.

So this gives us one rule to consider when we are fitting. The rule is: Never fit n data points with n parameters.

The reason is because you will generally get a 'too good to be true' fit as Larry Williams suggests. This rule generalizes. For example best practices include getting much more data than the number of parameters you are trying to fit. There is a statistical concept called degrees of freedom involved here.

Degrees of freedom is how much wiggle room there is in your model. Each variable you add is a chance for your model to wiggle to better fit the data. The rule of thumb is that you take the number of data points you have and subtract the number of variables. Another way to say this is the number of data points should be MUCH more than the number of fitted parameters.

It is also good to mention that the number of parameters can be tricky to understand. Looking at intraday patterns a parameter could be something like today's high was lower than yesterday's high. Even though it is a true false criteria it is still an independent variable. Choice of the length of a moving average is a parameter. Whether one is above or below is another parameter. Some people use thresholds in moving average systems. Each is a parameter. Adding a second moving average may add four more parameters and the comparison between the two
averages yet another. In a system involving a 200 day and 50 day
average that showed 10 buy sell signals it might have as many as 10 parameters and thus be nearly useless.

Steve Ellison mentioned the two sample data technique. Basically you can fit your model on one data set and then use the same parameters to test out of sample. What you cannot do is refit the model or system parameters to the new data.

Another caveat here is the data mining slippery slope. This means you need to keep track of how many other variables you tried and rejected. This is also called the multiple comparison problem. It can be as insidious as trying to know how many variables someone else tried before coming up with their idea. For example how many parameters did Welles Wilder try before coming up with his 14 day RSI index? There is no way 14 was his first and only guess.

Another bad practice is when you have a system that has picked say 20 profitable trades and you look for rules to weed out those pesky few bad trades to get the perfect system. If you find yourself adding a rule or variable to rule out one or two trades you are well into data mining territory.

Bruno's suggestion to use the BIC or AIC is a good one. If one is doing a multiple regression one should look at the individual t stats for the coefficients AND look at the F test for the overall quality of the fit. Any variables with t-stats that are not above 2 should be tossed. Also an variables which are highly correlated with each other, the weaker one should be tossed.

George Parkanyi reminds us:

Yeah but you guys are forgetting that without curve-fitting we never would have invented the bra.

Say, has anybody got any experience with vertical drop fitting? I just back-tested some oil data and …

Larry Williams writes:

If it looks like it works real well it is curve fitting.

Newton Linchen reiterates:

 my point is: what is the degree of system optimization that turns into curve fitting? In other words, how one is able to recognize curve fitting while modeling data? Perhaps returns too good to believe?

What I mean is to get a general rule that would tell: "Hey, man, from THIS point on you are curve fitting, so step back!"

Steve Ellison proffers:

I learned from Dr. McDonnell to divide the data into two halves and do the curve fitting on only the first half of the data, then test a strategy that looks good on the second half of the data.

Yishen Kuik writes:

The usual out of sample testing says, take price series data, break it into 2, optimize on the 1st piece, test on the 2nd piece, see if you still get a good result.

If you get a bad result you know you've curve fitted. If you get a good result, you know you have something that works.

But what if you get a mildly good result? Then what do you "know" ?

Jim Sogi adds:

This reminds me of the three blind men each touching one part of the elephant and describing what the elephant was like. Quants are often like the blind men, each touching say the 90's bull run tranche, others sampling recent data, others sample the whole. Each has their own description of the market, which like the blind men, are all wrong.

The most important data tranche is the most recent as that is what the current cycle is. You want your trades to work there. Don't try make the reality fit the model.

Also, why not break it into 3 pieces and have 2 out of sample pieces to test it on.

We can go further. If each discreet trade is of limited length, then why not slice up the price series into 100 pieces, reassemble all the odd numbered time slices chronologically into sample A, the even ones into sample B.

Then optimize on sample A and test on sample B. This can address to some degree concerns about regime shifts that might differently characterize your two samples in a simple break of the data.




 It seems that to be a trader these days you must have a PhD in Math. Actually how much math does a trader need?

I've been struggling with math since childhood, and I'm taking statistics personal classes right now. Recently Victor told me that I would only have had to count Galton's way and that would be enough. It seems to be easy to immerse yourself in deep math and forget about what the markets really are.

I know this lecture is from last year, but Soros has a good point when saying that the statistic models available fail to consider the role of uncertainty. When you are too much leveraged and the event goes too many standard deviations, you know you’re in trouble. Take a look at:

George Soros at MIT and

Quantitative Trading, an excellent blog on quants by Ernest Chan. His latest post:

This Quebec pension fund lost some $25 billion due to non-bank asset-backed commercial paper (ABCP). Their Value-at-Risk (VaR) model did not take into account liquidity risk. As usual, the quants got the blame. But can someone tell me a better way to value risk than to run historical simulations? Can we really build risk models on disasters we have not seen before and cannot imagine will happen?

The replies to the post were most illuminating:

quarterback said…

"Nassim Taleb's ”Fooled by Randomness” is a must read. Simply we don't live in a Gaussian world.”

Paul Teetor said…

"The NY Times recently quoted Taleb as saying, “VaR is like an airbag that works all the time, except when you have an accident.” I think that’s a perfect characterization.Can we prepare for what we have not seen? The folks in the insurance business have faced this problem for centuries. Some actuaries use Extreme Value Theory, and I’ve often wondered if the finance world needs to look more closely at that. Are the quants to blame for VaR’s short-comings? Sort of. I ran the VaR reports for previous employer — who got wiped out. In retrospect, I should have been telling everyone, “These numbers do not mean what you think they mean.” That was my error.”

Bill Rafter replies:

Dr RafterYou do not need an advanced degree in mathematics to be a successful trader. What you need firstly is the ability to think for yourself and secondly the ability to do research in a scientific manner. Regarding statistics, what you need to know is that one event is not significant, and that your highest return will not be your average return. Those are common mistakes of novices.

Most “quants” are employed in “risk” work. That is, they are given tasks such as, “assuming you have a certain profit, how do you protect it?” Or, “given a certain alpha, how do you make it portable?” Perhaps the best-known quant made his money by finding an anomaly in the contract specs of a certain futures market and then exploiting that. Those points suggest that your efforts at profitable trading should not be concentrated in the risk area. Instead they should be directed towards generating that profit or alpha that the supervisors assume is inherently there.

Let me pose a scenario: Suppose you had perfect knowledge that the broad market was going to rise, what stocks would you buy? The standard philosophy is that you would buy the ones with the highest beta, because they should go up the most. For the most part you would be disappointed, because those with the highest beta (i.e. past beta) would be the most volatile, as past volatility is equated with subsequent bearish performance. Don’t take my word for it; there are lots of academic articles saying the same thing.

Also — and this is important — would you rather trade an efficient market or an inefficient one? Obviously the latter, so do not waste your time with the efficient ones. Oh, but the risk guys love the efficient markets. Yeah, but the risk guys do not make money.

Let me give you our experience. We screen for risk early in our selection process, and never look at it again. We never use stops, which we feel simply provide certainty in losses. Except in the odd times when we are in bills, we never buy one asset because we cannot predict one asset well. On the contrary, our success rate in predicting baskets of assets is better, so we stick to that. Of course they are baskets where the early screening was on a risk-adjusted basis, but with no other attention being paid to risk. I am not suggesting that ours is the only way or the best way; only that it is a profitable method that does not hold the risk mavens up as gods.

Dr. Rafter is President of Mathematical Investment Decisions, a quantitative research consultancy



For those who surf and trade, riding a big wave generates the same kind of adrenaline as that of a trader who enters a large position in a volatile market. It makes me remember last October. I decided to spend the month only day trading, as the volatility was increasing.

I found something interesting: every time I entered a futures position, my heartbeat increased strongly. I could feel it in my veins! (One particular time –I swear I will never do it again! — I was trading so leveraged that I really felt like I had adrenaline pumping all over my body, and I felt I could break a window's glass just by pointing my fingers at it with focused mind…)

As I have a background in Physical Therapy I understood that too much adrenaline for a sitting body wasn't quite good. So I decide to see a cardiologist.

He immediately asked for an exam which consisted in a portable electrocardiograph device I should use for 24 hours. Ok. No problem. I should point in a notebook whether I was in a moment of tension, stress, whatever.

So I went to trading in the Monday of October 6th.

My "normal" heartbeat was 68, 70, 80 per minute. When I entered a trade, it immediately rose to 130! (Trading can really accelerate your heart.) This repeated every time I entered a position while in the exam. The doctor prescribed more exercise (any exercise would be good) as I gained some pounds after pursuing trading as a full time commitment. (If someone could lose weight thinking I would be as slim as Gandhi).

One of my all time disillusion was to perceive that I really fear big waves and I am truly a hot-dog surfer. So I would never, ever, ride a big wave.

At trading I am still paddling at waves way over my head. Sometimes.

Steve Ellison writes:

I just finished Blink by Malcolm Gladwell, a book about instantaneous judgments. One chapter of this book analyzes policemen who shot dangerous suspects. One policeman confronted a man who was holding a gun to the head of the policeman's partner. The gunman muttered an expletive and began to turn his gun toward the intruding policeman. For this policeman, time seemed to slow down. He felt his finger squeeze the trigger of his gun and saw the bullet hit the gunman. He fired three more shots and watched them all hit before the gunman fell. The next thing he knew, he was standing over the gunman, but had no recollection of having walked. He had not heard the shots his partner had fired.At a heart rate of 115-140 beats per minute, Mr. Gladwell writes, the brain intensely focuses on the perceived threat and shuts out extraneous information. However, if under more extreme stress the heart goes beyond 140 beats per minute, the brain narrows its focus so much that it misses important details and makes errors in judgment. Many police departments are making it a policy not to engage in high-speed chases because the chases put such extreme stresses on officers that their judgments are impaired. Three of the worst urban riots in the U.S. in the last 30 years resulted directly from the actions of police officers after high-speed chases, including the Rodney King case.In the rest of the book, Mr. Gladwell writes about some astonishing examples of "rapid cognition". A marriage counselor has a record of predicting, with over 90% accuracy, whether a couple will still be married in 15 years by watching them talk for 15 minutes. Several art experts instantly judged a Greek sculpture bought by the Getty Museum as a fake, while the Getty spent 14 months investigating the sculpture and concluded wrongly that it was genuine.

There is a chapter about Paul Van Riper , a retired U.S. Marine general who reminds me of Jack Aubrey. He is a fighting general who does not share the conceit of some military thinkers that the fog of war can be lifted by better communications and more data. In his view, data collection and analysis are fine before the battle, but worse than useless while fighting.Playing the part of a rogue Middle East leader, General Van Riper inflicted heavy losses on the American team in a large 2002 war game, partly by using low-tech communication methods (e.g., couriers on motorcycles) that were impervious to the American side's strategy of knocking out or intercepting electronic communications. He gave his unit commanders authority to make any decisions they wanted to in combat situations. At those moments, he wanted the commanders focusing "down" (on their units) rather than "up" (on their superiors). Mr. Gladwell notes that the thinking styles of military officers and commodity floor traders are strikingly similar.

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