Becoming a better trader (or investor) involves much more than expanding your knowledge of markets.
While the vast majority of market participants may believe that it is, they are incorrect.
The secret to trading success does not lie in external knowledge, but internal knowledge.
It’s about understanding yourself, how you make decisions, how you react to adversity, and how you think about markets.
If you can gain enough mastery of yourself, trading success will follow.
This Collection will show you how.
Everyone starts off wanting to be a profitable trader. Sadly, most fail to make money in the markets.
Here are 3 tips that will help you to make consistent and sustainable profits from trading and investing.
1. “Let Your Winners Run, Cut Your Losses Short”
This aphorism has been repeated many times, and bears repeating, because it is a fundamental tenet of trading and investing profitability.
Think of trading and investing as a simple numbers game, where the amount of profit you make must be greater than the amount of losses you rack up.
Bear in mind that we are talking about the total amount of profits versus the total amount of losses here, not the number of profitable trades versus the number of losing trades.
The concept as a whole isn’t hard to understand, since the same applies to everyday life. If the amount you spend is greater than your income, you’re in big trouble.
Likewise, if the total amount of trading losses you make exceed your profits, your trading account blows up.
Unfortunately for most traders and investors, the simplicity of the logic behind the aphorism means that they underestimate its importance. They understand what it says, but not what it means.
If you want to be a profitable trader, especially a consistently profitable one, you will need to learn how to trade in a manner that allows your winning trades to run, while closing out your losing trades early.
2. Follow A Set Of Markets Consistently
Avoid jumping from market to market based on trading tips that are trending on social media, the financial news, or what your friends are talking about.
Following a fixed set of markets consistently will develop your understanding of how each of them trades, as well as the nuances of their price action. Over time, this understanding will allow you to identify money-making opportunities in these markets easily, and consistently.
Conversely, if you keep jumping from market to market (or stock to stock), you will not develop this understanding, and will fail to learn how to identify decent trading opportunities.
This in turn means that you will almost always fall victim to the bandwagon effect, exposing yourself to large losses, which is precisely what you want to avoid (see tip #1).
If you are interested in trading ETFs and Macro, we cover a set of the most important ones on a weekly basis, giving you updates as well as trading opportunities in our ETF Edge and Macro Edge reports.
3. STOP Trying To Make A Quick Buck
What use is a 10,000% return if you lose it?
The issue at hand here is not that a 10,000% return is bad, because it isn’t. However, trading in a manner which cannot sustain the viability of your trading account is.
Successful trading, i.e. sustainable profitability, requires a set of skills that needs to be developed, and trading to make a quick buck is a surefire way to guarantee that you will not develop them.
If you do want to develop these skills, you will need to learn from experience. This means that you will have to trade in a manner that keeps your trading account alive while you suffer the losses and mistakes that are part of the learning process (see tip #1 and tip #2).
In this light, quick and large returns are inimical to your success as you will not learn what it is that you need to do, and not do, in the markets.
Ultimately, we can only ever act within the limits of our experience, which means that we need to survive the process of gaining it.
Even if you did manage to score an initial big win, doing so will only embolden you to take other reckless bets, since you simply do not have enough experience to know better. Of course, continuing to take reckless bets means repeatedly exposing yourself to the very high risk of bankrupting your trading account, which is a disaster that cannot be undone.
There really are no shortcuts to trading success. If you insist on finding and taking them, at least be aware that you are only sabotaging your chances of future success.
An effective trading plan will address the issues discussed above, and set you on the path towards sustainable profitability. Learn how to create your own here (it’s free!)
For a modern parallel to Newton’s misadventures in financial markets, think of Bitcoin’s sharp rise, and subsequent tumble.
Bitcoin rose sharply over 2017 – 2018, and topped out at just below $20,000, then proceeded to crash. Another meteoric rise followed in 2020 that peaked near the end of 2021 at around $68,000.
While stories of crypto traders who have made millions (or even billions) abound and draws even more people into the craze, there are many more folks who have traded Bitcoin in much the same way as Newton did during the South Sea bubble.
These traders either made a fortune and lost it plus more, or just lost their shirts without making a fortune at all.
The reason we only hear of those who made huge profits is the survivorship bias; people who lost big are simply forgotten or not discussed. After all, who goes around bragging that they lost a fortune?
It is important to note that all of this is extremely clear to us today because we are looking at the price chart with the benefit of retrospect. When we are in the midst of a market bubble, or a trade that has started to finally rack up asymmetric returns, it is impossible for us to know when prices have reached their zenith.
Consequently, in order to not fall prey to the disposition effect while trading to make asymmetric returns, we must trade in a fashion that works to mitigate the disposition effect, as detailed here.
On a broader level, astute readers would note that all of this sounds very similar to the concept of convexity, and how it applies to markets and real life. That is, to pay a small fee in return for a large payoff; and that’s because it is!
Trading for asymmetric returns is, at its core, an exercise in going long convexity in order to exploit the Paretian nature of markets.
More importantly, as the examples of Newton and Bitcoin so clearly illustrate, financial markets have always produced opportunities which generate asymmetric returns.
Regardless of the form they take; an old fashioned stock market bubble and crash, a housing bubble/crash, banking crisis, or hyped up new technology, all involve the same combination of greed, fear, and the opportunity to make, or lose, a life changing amount of money.
Unfortunately, while everyone wants to make a life changing sum of money, trading bubbles and crashes, or pursuing asymmetric returns in general, is a very difficult endeavor, again clearly illustrated by Newton and Bitcoin.
However, if done well and consistently, such an approach can, over time, produce significant returns, although requiring tremendous discipline, emotional control, and mental stamina.
Nothing is ever easy in life, much less trading the markets profitably. Give yourself as much of a chance to succeed as possible by starting on the right foot with a well constructed trading plan.
Understanding how to go about making asymmetric returns is simple enough, but actually being able to do it is not.
Since no one knows with certainty beforehand whether or not a trade will be profitable, much less be able to produce significant returns, one has to treat every trading opportunity as if it can.
This means that within whichever framework traders use to identify asymmetric trading opportunities (trend following, distressed debt investing, etc.), they have to be prepared to take losses.
Of course, this necessitates disciplined risk management, in order to keep the losses small enough so as to not limit their ability to make it all back when they do hit their asymmetric trade.
However, incurring many small losses is emotionally exhausting, and most traders give up and either stop trading, or change strategies before they ever hit a trade that produces asymmetric returns.
In addition, human traders are also susceptible to the disposition effect. This results in them exiting their winning positions too early, while letting their losing ones run for too long – the exact opposite of what they need to do when trading for asymmetric returns.
Sir Isaac Newton provides us with an excellent example of such behavior.
As the South Sea Bubble was inflating to epic proportions in 1720, Newton took the opportunity to sell off some of his holdings, and made a fortune in doing so. However, as the bubble kept growing larger, Newton got swept up in the market euphoria and went back into the market to buy more shares.
Unfortunately for him, prices turned down soon after (turns out he bought the high), then proceeded to plummet.
Instead of selling his now heavily loss-making position, he held on to them, and even bought more shares as prices fell (although not for himself, but for an estate of which he was an executor). As a result, Newton ended up losing a lot of money – the fortune he had made on South Sea stock previously, plus more.
From this anecdote, we can see that when Newton first sold his South Sea position, he was doing so too early, i.e. not letting his winners run. And, when the bubble began to burst, he held on to his losses for too long, instead of cutting them short.
In other words, one of the world’s greatest minds succumbed to the disposition effect, and it cost him dearly.
Intelligence clearly isn’t all that is needed to succeed in the field of trading and investing. Understanding oneself, and the nature of asymmetric returns are just as important.
To be continued…
Hang around traders or investors long enough and you will hear the phrase “asymmetric returns”.
While it sounds suspiciously sophisticated and impressive, “asymmetric returns” aren’t, like a lot of other financial jargon, pure marketing guff. They are, in fact, a reflection of not just how markets distribute outcomes (returns), but also how we can best profit from them.
Which begs the question, what exactly are asymmetric returns, and why are they so important?
Asymmetric simply means lopsided, or a shape that isn’t symmetrical.
The shape being referred to in this case is the risk/return profile, with the lopsided portion falling on the side of return.
Simply put, it means taking risks which offer the potential for outsized gains.
Since the risk taken is relatively much smaller than the returns on offer, the returns are asymmetric relative to the amount risked.
This is important because it directly relates to how markets really function, that is according to Pareto/Power Law distributions, and not, as widely imagined, Normal distributions.
Pareto distributions are asymmetric, with returns heavily skewed towards one side of the distribution, while normal distributions are symmetric, with returns evenly distributed into an aesthetically pleasing bell curve shape.
In essence, this means that returns from a financial instrument are inconsistent across time.
This is easily observed by pulling up any price chart, where, should the chart cover a long enough period of time, anyone can quickly see that prices spend most of the time in a range; that is, not doing anything.
In the rare periods of time where they aren’t range bound, they are either trending higher, or lower – sometimes doing so strongly.
These are the periods of time which generate meaningful returns for traders and investors, as prices are rising/falling quickly and by relatively significant amounts.
As such, traders have to trade accordingly to maximize their profit potential; taking advantage of times when markets offer the opportunity for making large gains, while keeping risk relatively small in order to avoid losing too much money when markets don’t.
In other words, trading in search of asymmetric returns.
Financial history is full of such trades, including the intrepid folks who shorted US subprime in the run up to 2008’s Great Financial Crisis – the trade made famous by the book (and later movie) The Big Short. More recently, we have Bitcoin’s meteoric rise from being mined but not traded in 2009, to trading at all time highs over $60,000 in 2021.
While many people tend to dismiss the folks who bought into BTC extremely early as being lucky, since no one knew beforehand that it would trade at such high levels, the trade is an excellent illustration of how to trade for asymmetric returns.
From a risk/return perspective, when BTC was trading for single digits almost a decade ago, the risk of owning them was negligible, simply because they were so cheap. At the same time, the potential for Bitcoin to generate outsized returns did exist, although the probability of it happening was low.
As such, buying into BTC back then, if seen from the perspective of risk/return, became a matter of asking “What’s the worst that could happen?”
If it doesn’t go anywhere, the total loss will be small, but if it does take off, returns could be astronomical; which is, of course, exactly what pursuing asymmetric returns is all about.
To be continued…
It is human nature to attribute our success to some individual attribute (that is often viewed very positively by society), and put our failures down to having bad luck.
This is of course a logical fallacy, since if luck can lead to undesirable outcomes, It follows that luck can lead to positive outcomes too.
Luck is a two way street.
While it is entirely possible that we did get unlucky, we can only safely say so if we did everything possible beforehand to achieve the desired outcome.
In terms of trading, this means that we entered into a position according to a well constructed trading plan with well defined risk management parameters.
If this process is robust and tested through different market conditions, then adverse outcomes can truly be attributed to receiving a poor toss of the cosmic dice. There is after all, a line beyond which every trader relinquishes influence and control over the final outcome – the point is to do everything possible before crossing the rubicon.
Should the process be flawed, or not followed properly, then a trader cannot fully blame negative outcomes on luck.
The problem with fully apportioning the blame for our failures to bad luck is that we are mentally absolving ourselves of responsibility for the poor outcome.
“It wasn’t my fault, no one could have foreseen this would happen.”
“It wasn’t my fault, I got unlucky.”
The words “it wasn’t my fault” are very dangerous to traders (and people in general too). By saying “it wasn’t my fault”, an individual is mentally bypassing the need for introspection.
Often, this comes down to people wanting to avoid the unpleasant emotions that poor outcomes cause them to feel. It is a modern day defense mechanism, in the sense that it allows us to deflect blame and hence avoid the bad feelings that failure elicits.
Unfortunately, avoiding blame also means that the individual does little reflection on what possible mistakes were made. Ultimately, to improve as traders, we have to run through the process of reflection and introspection in order to further refine our process.
If someone comes to the conclusion that nothing could be done differently in the lead up to the occurrence of a failure, then they can lament their lack of luck all they want. What truly matters is that they have gone about thinking about what they can do differently in the future.
A good way to illustrate this is with an example of a trader who employs a strategy that makes money by being short convexity.
While such a strategy makes small and consistent returns when volatility is low, it will lose a lot of money when a black swan event hits the market. When this happens, the trader’s first reaction would be to blame it all on bad luck, complaining that no one can know the future and when markets will crash.
But, is it really bad luck if you know beforehand that markets will crash and volatility will spike at some point?
While no one knows when this will happen, we do know that it will happen; not just from studying what markets have done before, but also from the way markets follow a Pareto distribution.
As such, stubbornly sticking with a short convexity strategy is playing with fire, or picking pennies in front of a steamroller, if you prefer.
This makes getting burned, or steamrolled, by the markets inevitable, and not a matter of bad luck, but wilful disregard.
Take the time to reflect on your trading mistakes and make changes to your trading plan and/or strategy if need be; your future self will thank you.
Get a different perspective on all things trading & investing every week!