In this column, I continue from where I left off the last time, namely, “The Importance of Personality in Trading.” I am sure many of you would have read the all-time classic Market Wizards by Jack Schwager. The first edition of this book is a compilation of interviews with the world’s top traders and if you have read it, I am sure you would have come across Richard Dennis in the book.
To give you a brief about Dennis, a commodities speculator once known as the "Prince of the Pit, he turned $1200 to $ 200 million in a span of 10 years. This indeed is a rare accomplishment. More interestingly, he did train a batch of traders who were called Turtles. The trading rule that Richard & his Turtles followed was to buy at a 20 day high, with the stop loss at a 10 day low or 2 ATR and to go short when a stock hits 20 days low with stop loss at 10 day high or 2 ATR. By using this simple strategy, he went on to become the world’s leading trader. The strategy sounds too simple to be true, so let’s check this with a live example.
On 11.07.2022 NIFTY made a 20 day high of 16,253. So as per the rules you entered the trade at 16,253. The stop loss (which is 10 days low) was 15,513 at the time of entry. Which in turn meant that the stop loss was 740 points away. Would you be completely comfortable with that kind of a stop loss? It turned out to be a great trade as NIFTY went on to make a high of 18,005 on 18.08.2022 which is 18,005 less 16253 = 1752 points gain from your entry level. Now that is huge. I know many systems don’t even make that kind of profit even in a year. The stop loss for the trade was 17,384 which was triggered on 29.08.2022. (it is 17,290 as the markets opened gap down (Gap down is when the price opens lower than your stop loss price) so your profit for the trade was 17,290 (stop loss) less 16,253 (entry) which is 1037 points. At one point you were sitting on an absolute profit of 1752 points (18,005 (High) less 16,253(Entry)) the give back is 18,005 less 17,290= 715 points. Could you have handled that? It would be difficult in a majority of cases, simply because it is human nature to get carried away by greed and one doesn’t even think to check if one has the personality to handle this kind of give back.
A majority of traders want to buy at the bottom and sell at the top. The first thought that would cross your mind is that the markets have already moved quite far away from the bottom and I am sure it will retrace, which it will many a times, so let’s wait for a retracement to buy. At times though, retracements may never happen and you sadly realize that you have missed the bus. Also waiting for retracement would mean violating the rules, right?
Secondly markets seldom go up in a straight line. During its up move in the above case it may have a minor retracement. It is at such times that one is tempted to book out of the trade for the fear of losing profits, and finally of the entire absolute move of 1752 points you end up with 1037 points, which is about 60 per cent, leaving the balance 40 per cent on the table. Would you be okay with that?
From my almost two decades of experience, let me tell you that no system will ever be able to catch the entire 100 per cent move, which is somewhat similar to trying to nail tops and bottoms. As Bernard Baruch puts it, “Nobody can nail tops or bottoms except for liars.” At times I have managed to nail the tops and bottoms, but I attribute it purely to luck, because if I say it is skill, then I should be nailing these over 50 per cent of the time, which is just not possible.
To quote Richard Dennis from an interview, “I always say that you could publish trading rules in the newspaper and no one would follow them. The key is consistency and discipline. Almost anybody can make up a list of rules that are 80 per cent as good as what we taught our people. What they couldn't do is give them the confidence to stick to those rules even when things are going bad.”
The system which Dennis used had a win rate of just 27 per cent. Simply put, of 10 trades one would encounter seven losing trades and only three winning trades. Do you have the personality to handle the same? The strategy which Richard was using was basically a long-term trend following strategy. Every strategy comes with its unique set of flaws and there is no flawless strategy in the universe. But this is the same system which helped him turn $1200 to $200 million.
One of the reasons why a person might would have problem following the system arises from the fact that it has a low win rate, namely 27 per cent. Right from childhood we have been hard wired to always be right and successful. Failure is considered a black spot. But this business is all about how big you win when you go right and how less you lose when you go wrong as said by the legendary George Soros. You need to let your winners run and not exit at the first sign of minor retracements. Basically, you need to wait for your stop loss to get triggered and in the above-mentioned case, be willing to give back almost 40 per cent of the move.
Even tail coating the strategy/system won’t take you further if it doesn’t suit your personality and eventually you could end up as losing while the person using the system from whom you tail coated in the first place, ends up winning in the long run. A small piece of advice that may help you, is that the longer the time frame, you may have a chance. The shorter the time frame the probability of success is extremely low, as less than 0.5 per cent.
So, firstly, you need to devise a strategy that suits your personality. When I say strategy, you need to define your entry rules, stop loss, exit rules, and risk. It could be based on moving averages, breakouts, P&F, Elliot Wave or whatever. Once you have devised a strategy that suits your plan the next step is to know whether the said strategy has an “Edge.”
What is an edge? I will talk about ‘Edge’ and its importance in the next column.
Follow the entire series here.
Kirit Manral is a professional trader, and has been running a mentorship program in trading since 2019, with mentees from around the globe. He can be found on Twitter at @KiritManral
