Trading

Marty Zweig famously coined the adage ”The trend is your friend till the bend at the end“. Trend followers are interested in securities which are potentially beginning long upward or downward price moves. They typically enter trades with exact limits on how much they are willing to lose on the trade which is known as a stop loss. Trend followers are looking for trades which will endure for many days, weeks or even months. What keeps these prices moving up or down to irrational levels? Cognitive bias and market psychology of course. By using disciplined money management, trend followers are looking for profits from winning trades to far outpace those of losing trades although losing trades far outnumbering winning ones. Trend followers do endure large account drawdowns as all traders and investors do because of the trial and error nature of their trade entries.

Swing traders similar to trend followers use technical analysis and charting to determine trade entries. They look for securities that will work in the medium term as prices 'swing' away from trend or alternatively as they revert to the mean and 'swing‘ back to trend. As we move out on the time horizon to monthly and quarterly timeframes the chance of achieving positive returns jumps greatly. For example for all months since 1950 the S&P 500 index has been up on average three out of every five months. With this win loss ratio, a successful swing trading strategy can be devised with exits of twenty-one trading days or less. Swing trades of many weeks or even months could also be devised however it would be likely to be more of a trend following strategy at that point.

Day traders are traders who make many small trades each day but are in cash by the end of the day. They view the market not as asset managers would with logically constructed portfolios but trading as merchants might view their stores and inventory as vehicles to earning a profit. Market returns on a daily timeframe have a roughly fifty-four percent chance of being positive forty-six percent negative essentially no better than flipping a coin. This reality creates the conditions for what is known as ‘gamblers ruin’ and is essentially why most day-traders lose money in the long run. The more frequent that day-traders trade, the worse their overall performance becomes. Even worse than the over-trading are the irrational alterations made to trading rules as cognitive bias, emotion and psychology creep into the rationale of these trades and on future trading decisions. 

"When an investor focuses on short-term investments, he or she is observing the variability of the portfolio, not the returns - in short, being fooled by randomness." Nassim Nicholas Taleb

In ‘Fooled by Randomness’ one of the five books in the excellent ‘Incerto’ series by Taleb he argues with interesting parables and fictional characters that short term trading systems of any kind cannot provide alpha from the market in the short run because performance and trend can only be determined over longer time frames. In this way the classic ‘gamblers ruin’ plays out for traders who engage in short run trading strategies like ‘day trading’ because the odds are as likely in this time frame of a security going up as it is to go down in essence the same probability of flipping a coin. Below I have presented excellent statistical studies as further proof of what Taleb clearly illustrated in his famous treatise over 20 years ago.