Trade like Sgt. Schultz

The worst trade of my “career” came in the midst of solid success. I entered a trade and promptly watched it go nuts. It peaked up about 22%. On its way up, I realized it was showing all indications that it was going up with no end in sight. I had seen this happen before, and I knew what was going to happen next. So as it went up, I tripled my position. Might as well cash in on a winner, right?

The next morning, I closed out the position down almost 15%. I took a massive hit to my equity because I “knew” the stock was going to go up. I had been fooled by some modest success into thinking I could wing it. It was rather devastating, yet I remain thankful for the experience. It was the first trade in which I totally deviated from my system, and I got nailed. And when I say I deviated from my system, I mean I deviated massively. I threw out my money management rules and exposed far more money to a single trade than my system allowed, thus increasing my risk. And I expanded my position at a price point that was much higher than my system allowed.

In so doing, I learned (all the way down to my bones) an absolute, essential rule for system trading. I know nothing. Nothing at all about an individual trade. All my knowledge is at the system level. I have an edge, but it has nothing to do with any specific knowledge of any particular trade. Rather, I know that if I follow my system over enough time and enough trades, the odds tilt in my favor. (At least, that’s the hypothesis under test.)

Let’s say you are holding a bag with 100 marbles, 55 of them red and 45 of them blue. You reach in (without looking) and pull out a marble. It is red. You then return the marble to the bag and shake the bag up. You do this 5 times and each time you get a red marble. Your knowledge of what just happened (you got a red marble 5 times in a row) and your knowledge of the overall system odds in no way means you know the next marble will be red. Or blue, for that matter. Your knowledge remains strictly at the system level: that over enough trials you will tend toward an average of 55% of the marbles drawn being red.

Statistics 101, yet in the heat of a trade, it is surprisingly easy to forget. If you want to learn system (or mechanical) trading, I suggest you trade like Sgt. Schultz. When looking at an individual trade, always remind yourself, “I know nothing.”

1 Comment

  1. Nils
    Feb 11, 2007

    Good advice. I’m convinced all human beings are wired to be bad traders. Successful traders such as yourself must work really hard to overcome an inherent bent toward losing that rears its head at the most unwelcome moments. As you say, that losing instinct always feels in the moment like a winning instinct until it’s too late!

    Soldier on, old man.