All Your Returns Are Up to You

I’m writing this blog to document my ideas on stock trading and to track my resulting performance. So why should YOU be interested? This is definitely not the first blog on someone trying to achieve their financial goals, but I hope to bring something different… ideas maybe not too mainstream, but that are commonly understood by those who outperform, and not just in trading. What I’ve learned so far can almost feel applicable to any situation in life where the possibilities are endless and it’s difficult to be consistently right. It can change your way of thinking, or even your outlook on life.

I realized early on in my career as a systems engineer that I would need to learn how to plan for retirement myself. No one was going to do it for me the way I wanted, nor would they do it for a decent price. I started my career at the height of the market euphoria prior to the mortgage meltdown 9 years ago. I even specifically remember being in Savannah, Georgia, mid-2007 when I turned on CNN and there is none other than Ali Velshi squealing in delight as the DOW hit 14,000. Literally the next day, Investor’s Business Daily reported on the potential of a sub-prime mortgage crisis. It took a little over a year later for the full stock market crash to really begin. The ‘American Dream’ for my generation of workers suddenly just became a lot harder to reach!

During this crisis, I began reading a lot about the markets and quickly realized that I could not trust the standard retirement model, that I could not trust most brokers, and that most mutual funds underperform the overall market due to lack of skill, high fees or the inability to be in cash during a crash. The more I read, the more I became interested in trading equities for myself, but as a noob, I made all of the following dumb mistakes we all make as beginner traders, our so-called ‘tuition fees’:

• Buying and holding
• Trading too many shares per stock
• Over-trading
• Holding losses too long, cutting winners short
• Getting emotionally involved with my positions
• Giving up at the bottom of a bear market

Thus, the first series of posts on my blog will discuss how I trade and how I aim at avoiding these mistakes. We begin below!

Find your Edge by Minding the Skew

The most basic thing you need to be a successful trader is an edge, an advantage in your trading that produces a positive net profit over the long-term. This edge is the culmination of all your research, planning, execution, and state of mind while managing your portfolio.

When you want to make money over the long-run, a good way to analyse a strategy is to look at the history of its returns as a population. You’ve probably heard of a bell curve before, a widely used method of describing how varied a population is with respect to an attribute, let’s say height in this case. The average height will usually be at the top of the curve. The curve slopes down to the left and right of the curves as the likelihood of very tall or very short people decreases. Its shape can be seen below, where the black vertical bar represents the average, or mean.

Let’s now imagine the average is zero and the curve below was actually a distribution of the profits for each trade in a strategy. You would see that you would never make any money. All the losses to the left of the mean would cancel out the gains to the right, rendering our edge pretty dull at the moment.

A Not-Necessarily-Normal Bell Curve

(source)

One way to obviously improve your odds is to get your average profit greater than zero. However this is not enough, because although you are now likely running a profit, you aren’t controlling risk, represented as the tail on the left side. What is most important is the old adage “cut your losses short and let your winners run”, one obeyed by all the great traders I’ve researched. When you do that you tend to incur many more little losses, but since your gains are essentially unbounded (the tail on the right), they usually make up for your losses and drive a profit. (The size of your bets matter too, but we’ll get to that another time!)

This active risk control can actually be demonstrated statistically, based on what is called “skew”. Skew shapes the bell curve such that the top of the bell curve leans left when positive, or leans right when negative. This makes the head kind of bobble to the left or right of the mean profit. Positive skew, which is what we are interested in for long-term strategies, also has the effect of reducing the size of the largest loss with the trade-off that the bulk of returns will be below average. If you take a look at the animation below, you can see this effect. It also shows how skew affects the median of the return, which gives you an idea of where lies that bulk. If you combine this with even a slightly positive average return, you are potentially looking at the profile of a winning strategy that is limited in the risk taken per trade. Knowing your risk in advance is great, especially when you can tune it to fit your own personal tolerances.

Note the head bobbles behind the mean while the largest losses are tucked in

If you’re wondering why I won’t trade a negatively-skewed strategy, for the most part they are dangerous, because while they have many small wins, they also incur very few but very large losses, losses that can quickly wipe you out! They also tend to be expressed in shorter-term strategies, which wouldn’t jive well with my full-time job.

One thing to remember is that when trading stocks over the long term (and by this I mean a few months to a few years for your winners), you are basically acting like a casino. The market is your deck of cards, and you are free to create whatever game you wish to play. Why not skew the odds in your favour?

This is also where I think trading psychology comes in. Your ability to incur those many small losses and hold out for the big winners is solely dependent on your ability to execute your trading plan flawlessly and maintain your edge. When you’re dealing with your own money, this gets very complicated, very quickly! But that is for the next post!

For more information about this blog’s genesis, mission and disclaimers, please see my links at the top.

Please feel free to comment below, write an email or contact me on social media:
Email:  mike@mindtheskew.com
Twitter:  @rocketpower
Stocktwits:  @rocketpower