My ‘System’

I put inverted commas around the word ‘system’ because a lot of people associate system with an automated process that is programmed into a machine using computer code.

That is certainly one example of a system but much more commonly for discretionary traders are a series of rules or combination of factors which go into putting on a trade, monitoring that trade and exiting that trade.

This then brings into play anything that influences those decisions such as time, availability of capital, availability of skills and resources as well as emotions, stakeholders (e.g. family, work colleagues, friends, sports teams), personality or disposition, people skills, research skills, your network, fears, hopes, dreams and aspirations.

The great thing about trading for me is that it is repeated decision-making. Regardless of what product or market you are involved in it always comes down to taking a position and seeing if you are correct. You are just repeatedly testing your judgement, with your Profit & Loss (PnL) showing you the sum of your efforts and abilities.

For that reason it is quite an introspective activity to be involved in. If you choose it to be so, it can be an opportunity for self-discovery or a frustrating and expensive form of entertainment.

I have read some excellent content on trading psychology which I have posted links to here.

Is this gambling?

Make no mistake whatever the illusions of high finance and representations of science, investing/trading is gambling and should be treated as such. I often hear people make a distinction between trading and investing. To me this is completely arbitrary and depends on the person providing the explanation. There’s just as much leverage and potential for loss (i.e. risk) in ‘investing’ in property or other asset class as there is in the ‘riskiest’ derivatives. It all depends on how you do it.

You are betting on a product, you are betting on an outcome, you are betting on a country, you are betting on a tax system, you are betting on quarterly results, you are betting on weather conditions, you are betting on demographics, you are betting on a counterparty.

It is for these reasons that many traders are aware of gambling theory and techniques, because of the applicability of betting on seemingly random events. The Kelly criterion for optimal position sizing is one such example of an application of gambling theory to financial markets and the business of trading.

You can search the internet for Kelly criterion calculators once you have some summary statistics about your historical performance in trading. The calculator will tell you how much you should be betting in order to maximize your returns assuming you are willing to risk all your capital.

Two important considerations for this exercise are:

  1. Would you realistically be ok with your account equity dropping by 90 or 95% and still betting the same amount as you did initially? That takes a lot of courage and in my experience is not that realistic, so people work around this by adjusting the amount they are willing to lose to be 30%, 50%, 70% or 80% of their initial capital.
  2. How reliable are your statistics on your own performance? If you are overly generous to yourself by overstating your win rate and average win or understating your loss rate and average loss then the Kelly criterion will return a bet amount that will make you lose money faster (because it’s telling you to get bigger).