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09/22/2011

The Trade-offs of Your Trading System


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Tradingsystem

Readers may believe that following your trading rules makes you exempt from feeling any emotions. But, unfortunately, you are human like me and your brain is built to respond to "the potential to make money" even more than the making of the money itself.

Those feelings are aligned and in business with your level of intelligence, and most of your are overly smart: you have CFAs, MBAs, and some PhDs. You have more intellectual brain power than almost all of your peers, friends, and colleagues put together, and your self-esteem is not unaware of this fact either.

And that's where it all starts to go south.


In an interview for my upcoming book, The Inner Voice of Trading, legendary trader Bill Dunn and I discuss the impact of emotions on trading and how they can betray the new trader. However, what separates Dunn from the pack is the emotional constitution that has come from a decade of scientific research as a university professor of Physics long before he began trading (and Dunn's track record goes back to 1974). Dunn has a PhD in Theoretical Physics. But, the fact is, Dunn remains an emotional being like the rest of us. As much as he is an expert in physics, he is an expert in self-awareness. Despite being fantastically insightful and intelligent, Dunn does not make trades outside of his model. We cover a great deal of this in the NYSSA Commodity Certificate Program available online.

Commodities


A good set of trading rules will have agreeable emotional and financial outcomes.  A trader is responsible for all that is done—and all that happens to their equity. Your model must be calibrated for both financial and emotional payoffs. In that paradigm, you do not get to blame the market for losses or whipsaws in your equity. If you make money on a trade, you may be a good trader or you may be lucky in the short-term. If you lose money, you may have poor skills or you may have had some bad luck. The only thing you can do is keep your losses small...and that's where the fun starts, because highly intelligent people don't like being wrong. It's not what they are used to.

To illustrate this, let's take a look at December COMEX Gold contract. The trendline has been broken after two drastically big down days, the day after which gold traded down to $1,700 per ounce. The volatility as measured by the Average True Range (ATR) has more than doubled over the last month or so, rising from $20 per ounce to over $44. That's a 120% increase. 

Translating that into dollars, you are looking at $4,400 of directionless volatility per contract of gold (which is standardized at 100 troy ounces per contract). You can think of the ATR as the contract's personality. 

Most professional traders typically risk a maximum of 1% per commodity per trade. In that regard, unless your account has $440,000 in net, unleveraged equity, gold futures are too volatile for you to trade now. In concert with the fact that the downtrend has been broken, you may still be bullish on gold on a fundamental basis. I am in that camp. 

However, with the volatility up 120% and the uptrend broken, if gold trades down to $1,700 per ounce, the question isn't "who is to blame?" It's "How do the emotional payoff of your trading rules serve you?"

 

–Michael Martin

Michael Martin has been a successful trader for over 20 years. Michael Martin is the creator of "Martin Kronicle," author of The Inner Voice of Trading, available for pre-order, and instructor of the NYSSA Certificate in Commodity Trading & Trend Following.

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