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Article Traders and Mistakes Part 1: Mechanical Traders by Van K. Tharp, Ph.D.
Trading Tip Should the Flash Crash Change the Way You Use Stops? by D.R. Barton, Jr.
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Traders and Mistakes Part 1: Mechanical Traders
I’ve always said that trading is mostly psychological and that traders should spend a lot of time working on their core issues. In fact, most of my Super Traders spend at least a year working on psychological issues before they get to work on their business plan or trading systems. One area where psychological issues can appear in trading is in mistakes.
So let’s look at the psychology of trading from the angle of mistakes. When you don’t follow your rules, you make a mistake. It’s that simple. And making the same mistake repeatedly is called self-sabotage. Self sabotage is another area of psychology rich with the opportunity for understanding yourself to improve your trading results. Here, however, we’ll focus on mistakes relating to some broad categories of traders.
First, let me introduce one way to measure mistakes' impact on your trading. Trader efficiency is a measure of how effective a trader is in making mistake free trades. So a person who makes five mistakes in 100 trades is 95% efficient. In the last five years I’ve requested that my Super Traders document their mistakes so that we can look at their efficiency levels. I have found that 95% is actually a very good trading efficiency level; many traders can’t even trade at 75% efficiency—which is terrible. That’s one mistake in about every four trades. This is most important for one category of traders: rule-based discretionary traders. In my opinion, when rule based discretionary traders become efficient, they are by far the best type of trader.
There are two other groups of traders I’d like to talk about: 1) mechanical traders and 2) no-rule discretionary traders.
First, we’ll look at mechanical traders. Mechanical traders believe that they can eliminate psychologically related trading problems by becoming mechanical. Many people aspire to be mechanical traders, letting a computer make all the decisions for them, because they believe it factors out many human-based errors.
In fact, one of my best trader friends said to me once that psychology didn’t enter into his trading because his operation was totally automated. My response was “You could decide not to take a trade.” About 18 years after I made that statement, his CTA business closed down. His partner decided against taking one trade—the trade that would have made their entire year had they taken it.
I’ve always said that people can only trade their beliefs about the market, so let’s look at some of the most important beliefs that a pure mechanical trader might have:
- With mechanical trading, I can be objective and not make mistakes (except the psychological mistake of overriding my system).
- Mechanical trading is objective. My system testing will allow me to determine my future results.
- Mechanical trading is accurate.
- If a system’s underlying logic cannot be turned into a mechanical trading system, it probably isn’t worth trading.
- Human judgment is too prone to errors. I can eliminate those through mechanical trading.
So then, is mechanical trading truly objective? I tend to think not because there are all sorts of errors that can creep into an automated trading system: data errors, errors in the software platform, errors in your own programming, and many more. (Interestingly, one of the main categories of errors that my Super Traders come up with consistently is programming errors.)
Let’s consider data errors. Is your data accurate or does it have bad ticks and other issues with it? Mechanical traders are always dealing with data errors of some sort. For example, price errors can show up in streaming data quite regularly. Sometimes those are resolved within seconds and the error “disappears” but, by that point, the bad data may have triggered a trade already. Additionally, historical stock data may or may not have dividend and split adjustments. And what happens when a company goes bankrupt? What if it goes private or is bought out by another company? Those companies’ data may simply disappear from your data set.
I once wanted to research an efficient stock trading system. We looked for efficient stocks (moving up without much noise) and bought them with a 25% trailing stop. We had an S&P 500 data set going back 40 years that was supposed to be clean and adjusted for splits and dividends. I was very pleased with the results because my system made a small fortune. I didn’t realize this at the time, however, but the system traded on “inside information.” Because of the data set, I was able to buy stocks at the IPO that would later become part of the S&P 500. Thus, my system, in back test, bought Microsoft, EBay, Intel, and many other companies before anyone knew they would become part of the S&P 500. Why? Because, as I said, my data set was today’s S&P 500 going back 40 years.
And what about Thursday May 6th, 2010? The Dow Jones dropped 1,000 points in the space of about 20 minutes. Blue chip stocks like Procter & Gamble dropped over 20 points, and Accenture even went to a penny per share briefly. While there may not have been one root cause for that mini-crash, it had a major effect on mechanical trading systems. Things like that happen in the markets; such are the challenges (error/mistakes) for mechanical systems. (That afternoon’s swing affected lots of regular traders, too. One client said he used 25% trailing stops on all of his positions and got stopped out of every single stock.)
Meanwhile, one of our instructors, Ken Long, trades rule-based discretionary systems and made 100R in that same week. As always, he was very conservative in his trading and very careful to make sure that he fully managed his risk.
There is another class of error that is made by mechanical trading systems: the error of omission. Because the criteria by which trade setups and entries are so precisely defined, mechanical systems miss many good (or great) trades that a discretionary trader would spot easily.
For example, suppose your systems screens for five consecutive lower closes. After you get five consecutive lower closes you then look for an inside day. Now you have your full setup. Your entry is a few cents above yesterday’s high.
So let’s look at some examples of other entry signals you might miss by being so precise. You could have four down days that were extreme—perhaps the price is down 30%. Or you could have less than four down days that where the price is 30% lower or more. However, neither of those example would be an adequate down move according to your strict mechanical criteria.
Let’s say you found something that had five days of new lower lows but the fifth down day might open on a new low and then close on a new high. That’s usually an extremely bullish signal, but you’d miss it by your precise definition. Or, you could have five days of lower closes and the sixth day opens on a new low but closes on a new high. Thus, the precise entry definition would miss a trade opportunity with even more weakness followed by an extreme bullish signal.
There are a lot more variations of this entry that a mechanical system would miss, but you get the point. As soon as you state your rules so precisely that a computer can execute the trades, you open yourself to errors of omission—good or outstanding trades that your automated system cannot take because of its precision. Those missed opportunities don’t qualify as mistakes but they severely limit the potential results of the underlying logic behind the system. The mechanical system results will look rather weak next to the results of a trader who used that same system and was allowed some discretion to take the all of those other trades that didn’t quite fit the precise mechanical system rules.
Next week we’ll look at mistakes and another type of trader: the no-rule discretionary traders.
Peak Performance Home Study
"You don't trade the markets. You trade your beliefs about the markets." —Dr. Van Tharp
What does that mean? How do you even find out what your beliefs are? Use this course to learn how to identify your beliefs and find out which ones are useful and which ones cost you money in the markets.
Should the Flash Crash Change the Way You Use Stops?
The May 6th “Flash Crash” was notable from several perspectives: psychologically, technically and also historically. The financial markets went into a brief period of “selective liquidity” on that memorable Thursday afternoon two weeks back.
For many traders, the biggest tangible results were stops getting hit and very inefficient fills. In some cases, stops were hit that had huge slippage (slippage is the difference between where an order was intended to be filled and where it actually got filled). Newspapers had stories of folks trying to liquidate positions and getting $100,000 less than they expected because prices were moving so fast.
While the event spawned numerous conversations for me, the two questions people have most frequently asked are, “What caused this monstrous price movement?” and “Should I quit using protective stops altogether or at least change to close only stops?”
As to the first question, no one has come up with a single, definitive cause. Most likely, there wasn’t one trigger but a series of events. Last week, we looked at the confluence of events that formed a type of “perfect storm” of market illiquidity to cause the panic drop and immediate snap back. Click here to read that article.
But now on to this week’s key question: Should the flash crash and evolving market conditions change the way you use protective stops?
Analysis of Stop Strategies
First, let’s consider the question: Should we even use protective stops at all? Protective stops, along with proper position sizing strategies, are a trader’s main line of defense against too much risk in any given trade. For practically all types of trading, the use of protective stops is mandatory for good trading discipline.
Now, let’s address a somewhat thornier question: Based on what happened to some stops on the flash crash day, should traders and investors switch to closing stops rather than intraday stops?
As with all sophisticated questions, there are advantages and disadvantages to both sides. Let’s take a look at them.
Standard Market Stop Orders
The standard tool for a protective stop is the market stop order. For a sell stop, the order is triggered when the instrument trades at the selected stop price. At that time, the sell stop order becomes a market sell order. Your order is then filled by the next available buyer at the market price.
For instruments with sufficient trade liquidity, there is rarely any slippage on market stop orders and the trades are usually executed very close to, if not at, the desired price. For example, in the very liquid S&P 500 e-mini futures market, my experience has been that at least 95% of all stop orders are filled at the desired price. In less liquid instruments, however, slippage may produce order fills at a price different than your stop because of the typically larger spread between the bid price and ask price. In fast moving markets, stops in all kinds of issues tend to experience significantly more slippage (in relative terms to their liquidity) than in normal markets.
With that background out of the way, we can look at the advantages and disadvantages for standard market stop orders. The major advantage of a stop market order is that it gets you out of your position immediately when the stop price is hit. Then, if the price continues to move against you during the rest of the trading day, you have safely exited at the price that met your stop criteria.
The main downside is mostly a psychological one: price can trade down to your stop (in the case of a sell stop), taking you out of the position and then rebound while you sit on the sidelines. This is what happened to so many traders with stops during the spike down and recovery on May 6th.
Market on Close Order
This type of order is designed to execute as close to closing price as possible. In this type of order (the sell version just to keep our examples consistent), if the price trades at or below your Market on Close (MOC) order price, a market order is triggered in the last minutes of the trading day to exit the position at the first available bid price.
This is considered a more sophisticated order type and is not available from every brokerage platform.
The advantages and disadvantages basically mirror those for the standard market stop order. On the plus side, if the market has excursions during the trading day that take you below your stop price and then back to higher prices, your position is preserved.
On the negative side (if the instrument goes below your stop price during the day), the price could continue to head down for the rest of the day. In this case, you suffer the additional loss of the price moving down until the position is closed at the end of the trading session.
What’s a Trader to Do?
It’s a classic standoff. Do you risk having your position exited during a potential back and forth price movement, or do you risk having a much larger potential loss if the price moves hard against you over the course of a single trading day?
Has anyone researched the topic? Luckily, yes. Next week we’ll look at some very interesting research that lends some objective market price movement data to the argument. Here’s the quick answer: for most traders and investors, MOC stop losses make less sense than standard stop market orders. Join us next week when we dig into the data!
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