Market Masters: Random Distribution And The Development Of A Belief System

David Blair

trading stocksby David Blair

There is a random distribution among winners and losers on any given set of variables defined as an edge.

Like most any pursuit of mastery, stock trading requires a certain set of skills to be successful. But unlike others the skills required have very little to do with action and everything to do with belief.

For example, the set of skills required to be an Air Force pilot is based on specific mechanical and technical training beyond a college degree, not to mention the physical and mental requirements necessary to handle and navigate such a powerful aircraft.  The learned skills allow the pilot to be in complete control of piloting the aircraft from point A to point B, except on those rare occasions when a mission is interrupted by an engine malfunction or some other potentially catastrophic event requiring the pilot to abort or maneuver an emergency landing.  It is understandable, then, that the high standards required prevent the majority of us from ever becoming skilled enough to actually pilot an Air Force aircraft.  I am in the majority.

For the trader, the technical skill is in identifying and recognizing a specific pattern or, as many like to refer to it, an edge.   The edge defines an opportunity for monetary gain based on a pre-defined set of variables. These variables are based on past history. Unlike the pilot, there is little required of the trader other than a chart and the recognition of an edge.  Anyone can obtain this pattern recognition skill regardless of educational background, age, or physical stature.  But there are specific skills that set the successful trader apart from the unsuccessful that have little to do with the chart and everything to do with beliefs. While few are able to become Air Force pilots for the previously mentioned reasons, few are able to become successful traders not for lack of education or physical statue but for lack of a proper belief system.

For example, one of the simplest and most recognizable trading edges is the breakout.  A trader can learn to recognize a breakout fairly easily.  In fact, most trading platforms offer a pre-programmed breakout signal, making it possible for anyone to identify and recognize this popular trading edge, yet most traders continue to consistently lose money with this and any other readily available trading edge.  By some estimates up to 90% of traders fail to succeed.  Why is that?  If the technical skill is easy, and anyone can obtain it, why do so many fail?

Most traders fail because they have not embraced a specific belief system required to navigate the uncertainty inherent in the stock market.  Unlike the pilot who rarely encounters the uncontrollable life threatening malfunctions, the trader faces uncertainty every trading day, and the realization that the outcome of each trade is completely out of his control.  Therefore, the skill necessary for trading success is not just in recognizing a pattern, such as breakout, but in developing and embracing beliefs about what to expect from the uncertain environment that defines the nature of the stock market.

The quote at the beginning of this post is from Mark Douglas’ book Trading in the Zone It is applicable to our understanding of a special set of trading skills that must be mastered if becoming a consistently successful trader is our goal.

This skills set requires a belief system based on an understanding of random distribution.  Now, I could share with you all the statistically complex principles behind the concept of random distribution but why bother?  I do not understand all the mechanics behind electricity but that is not going to keep me in the dark until I do. Simply put, the principle of random distribution requires us to accept randomness that is distributed without prejudice over a large number of like trades.  In other words, we can never know which trade will make money or how much, even if the current trade is like the last one in structure and form. As in the case of our breakout edge mentioned above, there is no way of knowing when a breakout will be profitable or how profitable.  In fact, the distribution of profitability is much like a coin toss, wherein we may have 6 winners (heads) followed by 2 losers (tails) followed by a winner then a loser and so on. Hence, random distribution.

In order to successfully navigate the uncertainty of random distribution, the trader must build a set of beliefs about his technical edge. This belief system should be based on the following:

1.  Acceptance that whatever variables are used in identifying an edge there is always the possibility that the current trade, and any trade thereafter, will not be profitable.  In order to prove this, all you need is one instance where an edge has failed in the past to know that it can fail at any time in the future.  Trades must be allowed to prove themselves in the present without historical prejudice.

2.  Recognizing that no matter how many variables are used one can never improve upon the 50/50 odds of success. If a trading variable can never be 100% successful then adding any number of others, each of which can never be 100% successful, will not allow the combination thereof to be any more successful. Two less than perfect variables can never become perfect together.

3.  Acknowledging that no matter how many variables are used in defining an edge there is always the unknown variable that can never be predicted.  We refer to these as the unknown unknowns.  News, for instance, that may adversely affect an otherwise perfect technical set up, can never be known beforehand.  Trade long enough and this one will cure us of relying on any illusion of consistently profitable predictions.

4.  Knowing that other market participants have and utilize their own trading edge that may be diametrically opposed to yours.  In the example above, there are those who trade breakouts to fail.  Believing that a trading edge is used by everyone at the same time and for the same reason is trading hubris best dealt with a dose of reality when the trading edge fails.

5.  Defining the technical variables of your trading edge requires, at one and the same time, defining the variables that identify the failure of that same edge.  If failure is not a consideration then nothing less than success is required.  Requiring that each trade be successful, especially the current one, will result is insurmountable losses, not to mention the frustration, anger, and anxiety associated with the refusal to accept such a loss.

So, when the pilot has acquired the proven skills to fly a highly sophisticated aircraft it is expected that a majority, if not all, of his prepared flights will end with a successful landing. A very small fraction of them do not.  The trader, on the other hand, once mastering a specific set of variables defined as an edge, cannot expect to profit from each trade.  In fact, he can expect, and should accept, that most of his trades will fail with the need to abort.  To think otherwise will result in a crash landing.

 

About David Blair:  David has been a full time trader and mentor for several years. His thoughts and insights on trading the markets can be found on his website CrossHairs Trading.  You can also follow David on StockTwits and Twitter: @crosshairtrader.

Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.

 

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