September 8, 2007

Book notes – Way of the Turtle - II

I have been reading the book – Way of the turtle for the past few days and have found it to be a good book. It is a book on trading. I posted my notes on the first two chapters earlier.

Notes on 3rd, 4th and 5th chapters follow –

The third chapter refers to the risk of ruin. This is risk a trader faces that several of his trades will go against him and he could lose his entire capital. The way to manage this risk is via Money management. This involves putting the position in small chunks called as units which are sized based on the type of the market, volatility measure of the market etc (please refer to the book for more details).

The third chapter refers to four key points

- Trade with an edge: Find a trading strategy which can produce positive returns over the long run as it has a positive expectation (see an earlier post on edge, kelly’s formulae etc here)
- Manage risk: Control risk via money management discussed earlier
- Be consistent: execute plan consistently to achieve the positive expectation of the system.
- Keep it simple

All the above points are equally valid for an investor as it is for a trader.

The fourth chapter focuses on thinking in the present and aviod thinking of the future. Successful traders do not attempt predict the future. They do not care about being right, only about making money. A key point is that good traders are also wrong a lot of times. However they do not beat themselves over it. They are focussed on sticking to a plan and trading well and not worrying about the success of each trade or do not look at each trade as a validation of their intelligence.

One of the biases namely recency baises can impact a trader severely, especially if he is on a losing streak. People have a tendency to overwiegh recent data. Recency bias results in a trader over wieghing recent performance, especially bad performance and the trader may end up abondoning a successful system. The way to avoid this bais is to focus on probabilities and to know that every system has a certain odd of failure (A certain number of trades will go wrong). However by focussing on the process than the outcome and being confident that the system works well in the long run, one can remain rational and continue with a successful system.

The fifth chapter discusses about the concept of edge in more detail. The chapter introduces various concepts such as MAE (maximum adverse excursion – loss over the time frame) and MFE (maximum favourable execursion – gain over a time frame). The E-ratio (edge) is ratio of MFE/MAE adjusted for volatility. This ratio can calculated for various duration such as 10 days, 50 days etc.

To find an edge, you need to locate entry points and exit points where there is greater than normal probability that the market will move in particular direction within the desired time frame. The various components that make an edge for a system comprises

- portfolio selection : alogrithms which markets are valid for trading on any specific day
- Entry signals : alogrithms that determine when to buy or sell to enter a trade
- Exit signal : alogrithms that determine when to buy or sell to exit a trade


Ranjit kumar said...

Hi rohit,

The sentence "They do not care about being right, only about making money" is a bit ambiguous. For example if i am right in the market i will make money and if i am wrong i might have a cover for it but will not make any money. Can you give me an example where even if the decision is wrong we will still make money. One example comes to my mind, You buy a stock for a reason, and you are wrong but still the stock goes up for some other reason. The above case doesnt need any expertise right.

Ranjit kumar

Rohit Chauhan said...

hi ranjit

i think the context of the above statement is that even if the trader is wrong 40-50% of the times, if he is right by a bigger margin than he is wrong he will make money. so in that sense it is important by how much is one right than wrong

i agree with your conclusion for an investor. one can buy a stock and it can be successful for the wrong reasons too. i would however still consider it as a failure even if i made money ( focus on process rather than the outcome). however the above statement for an investor means that even if he is wrong 30-40% of the times and looses money on them, if his wins are big enough he may still do well

Anonymous said...

I've heard the quote before, and the way I understand it, is that people don't like to admit they are wrong. So when you buy, and the stock drops, you don't sell when your mental stop is hit, because that is admitting you made a mistake in the purchase. That is a fear that could end a trading career.
Now, the stock could turn around and make a profit. Does that make you right? No - holding on beyond your stop is the wrong decision. The problem is you may be rewarded by the market for making that wrong decision, which reinforces the habit of not following your own rules!
This is an example of how being "right" would mean taking a small loss, and being "wrong" could make a profit. Which habit would a winning trader want to foster? The one that makes money long-term (following your rules and taking your loss while it's small), NOT the one that makes you feel good because you were "right" by buying and holding forever.

As I understand it, that is the meaning of the quote, "They do not care about being right, only about making money"