Sunday, January 13, 2013


The quickest way to lose money in the market is not from ignorance. It is from overconfidence. If you overestimate your edge, or even have negative EV,and trade according to a Kelly formula which I discussed years ago, you are putting yourself at risk of a crippling drawdown and eventual KO.

Compounding works both ways. It makes multiplying your money faster but also makes it much slower to comeback from deep losses. Losing 20% of your money 3 times in a row (1 to 0.80 to 0.64 to 0.512) has a less negative effect on your bankroll than losing 50% one time (1 to 0.50). After losing 50%, it takes a 100% return to get back to the starting point. After dropping 80% of your money, it takes 400% return to get back to starting point.

Let's say your have a trader that follows Kelly betting to optimize the growth rate of bankroll, and believes he wins on 3 out of 4 trades, or has a 75% win rate for 1 to 1 risk reward bets, thus would bet 2(0.75) - 1 = 0.50, or 50% of his roll on each bet. But in actuality, he has an expected 60% win percentage. A random sample of W W L L W L W W L W (6 - 4) would result in the following: 1, 1.5, 2.25, 1.13, 0.56, 0.84, 0.42, 0.63, 0.95, 0.47, 0.70. Despite an expected value of profit of 0.44 (44%) (6 wins, 4 losses), the account shows a loss of 0.3, or 30%. There in lies the danger of overbetting due to overestimating your advantage with Kelly betting. Unlike blackjack, it is impossible to determine your exact edge on each trade in the financial markets. So one must err on the side of conservatism when following Kelly.

From experience trading both stocks and futures, in the futures market, you just won't find some of the big edges that you can find in individual stocks. There is a definite tradeoff between liquidity and percent edge. The less liquid markets provide bigger edges for those that know what they're doing.

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