Caveman Discretionary Trading

In the beginning, it is about finding an edge, a setup that works over the long run, through multiple market cycles.  Backtesting that setup and also making sense of why there is that edge.  It is not some random thing that worked in the past that you just expect to keep working in the future.  There is an underlying bias or behavior among market participants that create the pattern. 

For example, a lot of retail traders are looking for a quick buck, a volatile small cap stock that is in play and going up on some hype press release from the company.  They see it going up and can't help themselves, they get FOMO and chase a stock that's already up a lot on nothing fundamental.  So they push the stock up to unsustainable levels.  Eventually it goes back down as they sell when the excitement fade away.  Some of these companies will take advantage of the higher price and volume generated by these traders and ram through a stock offering.  Even without an offering, the natural force is to the downside once the high volume frenzy calms down, usually within 2 days.  The classic pump and dump pattern.  

Finding an edge takes time and experience, but its only the first part of game.  The next part is discipline.  Discipline is mainly 2 things:  1) risk management.  2) trade selection.  Once you find your edge, keeping that edge is easier than keeping your discipline.  

For a lot of people, discipline is a function of results.  It is easier to maintain discipline when you are making money than when you are losing money.  There are a lot of trading cliches that are useless but the one about trading smaller after a big loss is useful, but psychologically difficult to implement.  That's due to our caveman roots.

After you have been winning, you feel good, and don't want to risk losing that good feeling by trading bigger, even though you can, with the same level of risk, because you now have more capital.  After you have been losing, you feel bad, and don't want to keep feeling bad.  So how do people cope with that feeling?  They trade bigger, even though they have less capital now, increasing the level of risk after losing.  That's revenge trading.  Taking less risk while winning, and taking more risk while losing. 

Revenge trading is what happens after you lose money on a trade and also lose your discipline.  It has been the bane of my existence.  If I never revenge traded in my career, I would have a lot more money right now.  And I don't think I'm the only one.  Its the caveman in us that is hard to contain.  The urge to double down.  This urge is especially strong in mean reversion traders.  That is the biggest edge that trend followers have over counter trend traders.  Trend followers have better risk management.  

The next aspect of discipline is trade selection.  Its much easier to maintain the same trade selection when you are winning than when you are losing.  When you are winning, you feel good, so you don't want to lose that feeling by making too many trades.  When you are losing, you feel bad, so you want to quickly get rid of that feeling, and become desperate to find the next trade to make back your losses, to get back to even.  So most end up loosening their trade criteria and get desperate trying to make their money back.  This can lead to a downward spiral of entering subpar setups which leads to more losses and more desperation.  It continues to feed on itself until you start making money again and even at that point, if you are still down a lot, you can still have that desperate mindset which makes it that much harder to get out of the hole.  

The flip side of compounding is losing so much that its almost impossible to come back.  If you start with 100, Losing 50% of your bankroll, and then making 50% back leaves you with 75, not 100.  Losing 90% of your bankroll and making 90% back leaves you with 19.  Excessive risk taking and volatility in your account is a negative drag on long term account growth.  I wrote about overbetting and  optimal bet size several years ago.   

That's why you can teach people the right setups to trade, and still the majority of them will screw it up because they lose their discipline.  

The bounce back from that overnight dip to 4350 in European hours on Thursday has gotten the SPX back to the pre-FOMC minutes break down level of 4440.  Call me old-fashioned, but the 15 minute chart looks like its begging for a retest of 4350 at a minimum in the coming days.  Definitely not shorting, as I refuse to short SPX until after the parabolic rally phase, but it seems odds favor the bears here.  Also, I find it interesting that you got the biggest equity inflows since March 24 last week, as the SPX was weakening from all time highs.  It looks like FOMO has finally caught up as the SPX kept grinding to new all time highs.  Those on the sidelines couldn't take it any longer and decided to pile into equities.  Seems somewhat ominous to me, but doesn't derail me from the BTFD strategy. 

If we do get back down to 4350 or even lower this week, I would be a buyer expecting Powell to be a cooing dove at Jackson Hole ahead of his reappointment decision, with Delta variant as a very convenient excuse. 

Similarly, I am a buyer of dips in Treasuries ahead of the 2/5/7 year auctions and Jackson Hole.  The power flattening over the past several days is consistent with tapering fears in the market, and everything in my gut tells me that Powell will be more dovish than expected on Friday.