Know Your Process

It is said that the definition of insanity is doing the same thing over and over again and expecting different results. The thing is that if you do the same thing over and over again in the market, you will get very different results, because the market environment constantly changes. The same type of swing setups that have 80% success rate and average 20% returns in a healthy bull market, could have 15% success rate and 10% returns in a choppy market. The same market approach (process) could have extremely positive or extremely negative expectancy, depending on the market environment.

Expectancy is the average gain per every taken signal. Highly positive expectancy means that you have an edge.

Expectancy = %of winners * Avrg. return of winners – % of losers * Average return of losers

Let’s assume that no matter what the market environment is, we keep our losses to 6% on average. What are the results in a healthy and in a choppy market?

Healthy market

Expectancy = 0.8*0.2 – 0.2*0.06 = 14.8%, which means that if your average capital allocation per signal is 10%, the average profit per every taken trade will be 1.48% of your capital. If you take 100 trades in this environment, your return will be 148%. (not taking into account that the absolute capital allocation will change as your capital grow).

Choppy Market

Expectancy = 0.15*0.10 – 0.85*0.06 = -0.036 or -3.6%. If your average capital allocation is 10%, then your average return per every single taken trade will be -0.36% of your capital. The more active you are in this environment, the more money you are likely to lose. In this case, we basically have 4 options to help us mitigate the damage:

1) trade less

2) use smaller position size (1/3 to 1/2 of your usual)

3) sit on the sidelines

4) use another approach that has a positive expectancy in this market environment (also known as an edge)

We don’t know in advance what trade is going to work, but we could have a very good idea when we have an edge and when we don’t.

I like to repeat that sometimes being wrong in the market is not a choice, but staying wrong always is. The truth is that more often than not being wrong in the market is a choice, kind of. If you know when your bread & butter process does not deliver in certain market environment and that you are very likely to encounter a loss, don’t push it, don’t be more active.

Many people know when their market approach is not likely to deliver good results, but most don’t have the discipline to step away and watch mostly from the sidelines. I have to admit that I have been one of those people. I am very good at knowing when to trade less and cut my position size, but at the end of the day when I draw the line, it turns out that in this specific environment I would have been better off doing nothing and sitting on the sidelines.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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