Would You Pass the Trader Test?

Businessman holding money  - Australian dollars
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Never before have grades been so important. They are the yardstick by which we measure ability. It seems you can’t get anywhere these days without good grades.

I was talking to a friend the other day. She works at a big multinational in Sydney. It turns out, a university degree is the bare minimum to get an interview — although a Masters would be better.

Now that’s a tall order. It automatically culls a big chunk of the population.

So are grades really the be-all and end-all?

Well, Google says no. Laszlo Bock is Google’s Senior Vice President of people operations. He says that grades alone are not a good predictor of career success.

Google instead hones in on something called learning agility. This is essentially a person’s ability to adapt. These flexible thinkers can move outside their comfort zone and learn from mistakes.

And you know what. A 2011 study ranks learning agility as the best indicator of success — outscoring both IQ and education. So maybe the highest score isn’t the best guide after all.

I recently read a fascinating study. It centred on cadets at the West Point Military Academy. And again, grades are in the thick of it.

You see, entry grades are a key input in judging who’ll make it through. But it turns out there is a better predictor — the ‘Grit Test’. It essentially measures persistence and resilience.

The findings were amazing. Cadets with high Grit scores were most likely to finish the gruelling program. This was regardless of their academic grades.

And it makes sense. You don’t have to be the school dux to excel. But you won’t make it big by quitting after an early setback.

So again, high grades aren’t the best indicator of success. There are other factors to consider. Only then can you make an accurate assessment.

The idea that high grades predict success has relevance to trading. You see, many people believe good traders have high win rates. They view the strike rate as a key measure of success.

Let me give you an example. It’s from a conversation I had a few years back at a wedding.

I got talking to a guest about trading. He was working at a telco. But his goal was to be a trader. I was working at Bankers Trust at the time, and my new friend wanted to know all about it.

One question sticks in my mind. He asked me what my strike rate was. In other words, he was asking what percentages of my trades made money.

My answer was about 35% to 40%.

I remember his response vividly. He said ‘Oh, that’s honest

I paused for a moment. Then it struck me. He though a low strike rate was bad. In his mind, I was confessing that my trading career was in tatters. We had a serious disconnect.

I then added some key information. This made all the difference. I explained my average winning trade was more than three times my average loss. This meant I was actually a very profitable trader.

But I can understand the confusion. The internet is full of ads for all sorts of trading services. Many claim to have exceptional strike rates. This plays on the thinking that ‘high grades’ equal success.

Have a look at the following table.

Suppose you want to hire a trader. Whose CV would you look at first?

Most people would go with trader A. Again, it’s that natural tendency to link a high grade with success. But that’s only part of the story. Let me add some more information.

Trader A is no longer top of the class. It’s trader D making the most money.

These aren’t a random set of numbers. They are actually from some back-testing I did last week. My aim was to test two exit strategies — taking profits and letting winners runs.

All I did was modify Quant Trader’s exit algorithms. There were no changes to the entry or risk management strategies. The test period is between 1 January 2009 and 10 July 2015. Each trade is for $1,000. And there is no allowance for costs or dividends.

Here’s the final table. It shows the results from four scenarios.

The first two strategies are similar to how many people trade. Locking in an early profit typically leads to lots of small wins. The problem with this is that it caps profits.

The third strategy gives profits scope to run. It then takes profit if a stock rises by 100%. The final example is Quant Trader. Profits are let run until the stock hits its trailing stop.

Now, you may be thinking the 5% take profit strategy isn’t that bad. It seems to make good money. And you get plenty of winners to boot.

But there’s a catch

Look at the number of trades when you take 5% profits. Now look at the average profit per trade. This strategy may well lose money after brokerage.

And don’t forget, these tests use Quant Trader’s entry and risk management strategies. Many traders don’t have a robust method for either.

The 20% take profit strategy is a bit better…although it’s no standout.

It’s only when we let the winners run that things get interesting. The number of trades drop, and profitability rises. The longer holding periods are also more likely to result in dividends.

I have one last thing to show you. The following chart brings all the numbers to life. It graphs the hypothetical performance of the four strategies.

There is no doubt about it. Letting winners run makes a huge difference. Sure, you’ll have a lower strike rate. But that’s okay. A high strike rate is not a good predictor of success.

Trading isn’t about being right more often…it’s about making money.

Until next week,

Jason McIntosh

Editor, Quant Trader

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The Daily Reckoning offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, The Daily Reckoning delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors. Founded in 1999, The Daily Reckoning is published in 7 countries with a worldwide readership of almost 1 million people.
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