The philosophy of systemic trading just became clearer to me over the past few days.
Over the past couple of months, I’ve asked myself the question – if every trade is an independent, random event, much like a coin toss, how can one ever hope to be profitable in trading a so-called “system”? What if the Efficient Market Hypothesis (EMH) pundits are right? A coin toss is an independent event – the odds of Heads or Tails coming up are always 50/50, regardless of the history of tosses. Anyone who tells you that there’s a “system” of betting whenever there has been a streak of 3 Heads in a row is bullshitting you. (The same logic applies to the weirdos who claim to be able to predict the outcome of Roulette tables or lotteries based on which numbers have come out before)
A trading system comprises of hundreds and hundreds of trades – each one with its own probabilities and risks – any trade is a random event. But here’s the clincher – even though the outcome of any individual trade is random, the outcome of a LARGE COLLECTION of such trades is no longer random. When you put a large, statistically significant bunch of uncertain events together, they paradoxically give rise to a certain outcome.
Skeptical? Think about how casinos make money. At any given time, a casino is the counterparty to hundreds of bets: blackjack, roulette, craps, slot machines, etc. Each individual bet is uncertain, and there are thousands of variables that a casino cannot control – how much a gambler bets, when she hits or stays, what the dice rolls will show, etc. Yet, put them all together and we all know that a casino is GUARANTEED a profit. As long as people keep coming to play, profits roll in month after month after month.
The secret is in the EDGE. Each individual bet, while it is uncertain, gives the casino a minuscule edge over the gambler. In blackjack, it could be as tiny as 2%. Yet that 2% is enough to make money – of $40m in bets, the casino walks away with a cool, guaranteed $800,000. Not bad. This edge takes into account all the big winners, the high rollers, the big losers, the small losers, the smart gamblers that walk away with $50 in profits, etc. Put everyone together and the public effectively hands the casino its edge.
Going back to the coin-flipping example, perhaps a trading system is more like a coin flipping game with slightly better odds. Perhaps you will win $1.01 for every Head that comes up, and lose $1.00 for every Tail that appears. The edge, in this case, is 0.5*1.01 – 0.5*1 = 0.005, or 0.5%. You don’t know the outcome of any given flip. In fact, you could hit a streak of losses and hit 10 Tails in a row. But you know that if you keep playing over the long run, you’re GUARANTEED a profit of 0.5%.
So what’s the edge in my chosen trading system? It’s as simple and fundamental as Newton’s First Law of Motion: An object in motion stays in motion in the same direction unless acted upon by an unbalanced force. Prices tend to keep going where they’ve been previously going. This isn’t some hypothetical belief that I’ve plucked out of thin air, academia has unequivocally shown that autocorrelation exists across all asset classes. Today’s prices aren’t a random, independent coin flip, they’re dependent on yesterday’s prices, and are likely to be in the same direction.
One musn’t confuse an edge with probabilities. An edge has 2 elements – payoff and probabilities:
Edge = (probability of winning x payoff of winning) – (probability of losing x payoff of losing)
You could win only 1/3 of the time, but if your payoff is large enough to compensate for the low probability, you have an edge. In fact, that’s how the majority of trend-following systems work. Trends only appear about 30% of the time, but trend-following allows you to keep the profits large when they DO appear, which more than compensates for the many tiny losses that the system might incur. Hence, a trend follower is never dependent on any single trade or even a streak of trades to make or break her. A trend follower acts on every single trade, every single opportunity, not caring about the outcome of any single opportunity, because she knows that every single opportunity, good or bad, adds to her count and helps her get into the “long run”, where there’s a certain, guaranteed outcome. She knows that if she sticks at it, she’ll come out on top.