Take two traders who win 40 percent of the time with their winners being three times as large as their losers. One has a history of 1,000 trades and the other has a history of 10 trades. Who has a better chance in the next 10 trades to have only 10 percent of their total trades end up winners instead of the typical 40 percent? The one with the 10–trade history has the better chance. Why? The more trades in a history, the greater the probability of averages holding true. The fewer trades, the greater the probability of moving away from the average.

Consider a friend who receives a stock tip, makes some quick money, and tells everyone about it. There is a big problem with this scenario. His population of winning tips is extremely small–one to be exact. That’s statistically insignificant. He could just as easily follow his next hot tip and lose all of his money. One tip means nothing. The sample is essentially anecdotal evidence.

Thinking in terms of statistics is everywhere if you are observant. During a Monday Night Football game, one of the announcers, Ron Jaworski, put numbers and odds in perspective for playing the game of football: “Play calling is about probability, not certainty.”

It is the same in trend following trading.

Note: See more in Trend Commandments.

From Taleb:

Why is surprise the permanent condition of the U.S. political and economic elite? In 2007-8, when the global financial system imploded, the cry that no one could have seen this coming was heard everywhere, despite the existence of numerous analyses showing that a crisis was unavoidable. It is no surprise that one hears precisely the same response today regarding the current turmoil in the Middle East. The critical issue in both cases is the artificial suppression of volatility — the ups and downs of life — in the name of stability. It is both misguided and dangerous to push unobserved risks further into the statistical tails of the probability distribution of outcomes and allow these high-impact, low-probability “tail risks” to disappear from policymakers’ fields of observation. What the world is witnessing in Tunisia, Egypt, and Libya is simply what happens when highly constrained systems explode.

Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to “Black Swans” — that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.

Such environments eventually experience massive blowups, catching everyone off-guard and undoing years of stability or, in some cases, ending up far worse than they were in their initial volatile state. Indeed, the longer it takes for the blowup to occur, the worse the resulting harm in both economic and political systems.

Seeking to restrict variability seems to be good policy (who does not prefer stability to chaos?), so it is with very good intentions that policymakers unwittingly increase the risk of major blowups. And it is the same mis-perception of the properties of natural systems that led to both the economic crisis of 2007-8 and the current turmoil in the Arab world. The policy implications are identical: to make systems robust, all risks must be visible and out in the open — fluctuat nec mergitur (it fluctuates but does not sink) goes the Latin saying.

True.

I put this great quote in my bestseller Trend Following:

“What is striking is that the leading thinkers across varied fields–including horse betting, casino gambling, and investing–all emphasize the same point. We call it the Babe Ruth effect: even though Ruth struck out a lot, he was one of baseball’s greatest hitters.”

Get it? You have to get it–to survive. Ever hear political leaders talk like this? No, political leaders promote the nonsense that there will never be a stubbed toe again. Believe that?

From The Little Book of Trading:

The reality? Markets are often in “tail” situations that can produce sizable profits–profits that, over time, will sig­ nificantly outweigh losses that may occur when markets are not operating within tails. When I say tail, think back to that stats class you probably hated. The tail of the bell curve is what I mean: extreme events that are supposed to be very rare, but actually happen quite regularly in the markets.

Meaning, we all know the world is chaotic. We know surprises happen. We know that trying to explain the world with a perfectly symmetrical bell curve, a normal distribution, is not smart…so why not build a trading strategy to take advantage of that?

Simple. Wise.

Stephen Horan writes:

Everywhere we turn, psychological tests are available to help us better understand ourselves and our own behavior. But often these tests fail to shed light on a person’s relationship to risk, particularly the risk of losing money.

That’s why I like to do my own thought experiment. When I speak to groups, I often ask the participants to consider the following scenario:

Suppose you are sitting in a captivating presentation and someone comes in and locks the door. Then the person announces that everyone in the room is free to leave under two circumstances. You can leave if you pay a $1,000 fee (à la Hotel California) or you can leave after flipping a coin and going double or nothing. If the coin turns up heads, you exit for free; if it’s tails, you pay $2,000.

On a consistent basis, some 80 to 85% of the people in the room choose to flip the coin. The results are always very biased toward flipping, and that says something about the human tendency toward loss aversion.

The classical theory of the rational, economic man would have him avoid risk and thereby avoid the coin flip. The difference in this case, however, is the negative expected returns (a loss of $1,000 in each case since with option B you have a 50% chance of paying $2,000).

Since negative returns are at play, a loss aversion mechanism kicks in, and people will actually go double or nothing in order to keep from losing—thereby taking more risk.

The first reaction I get is surprise from people who otherwise think they make “rational” decisions regarding money. They realize for the first time the innate nature of loss aversion. That’s why I put the term “rational” in quotes. People are not necessarily “irrational” or stupid on this point; they are simply being human.

That thinking is foundational to becoming a successful trend following trader.

Note: Shout to Alistair Evans for the hat tip.

From NY Times:

Mutual funds are run by highly experienced and hard-working professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than 50 years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year.

That’s but one great nugget. Read it.

Note: Shout to Ritholtz.com for the article find.

Reminds of the two bubble theory again…

Shout to Ritholtz.com.

An excerpt from: The Secret World of Jim Simons by Hal Lux:

Like all quantitative money managers, Renaissance aims to find small market anomalies and inefficiencies that can support profitable trading on billions of dollars of capital. Though all quant shops are alike in their dedication to models Let the best algorithm win! Renaissance’s approach differs from the “convergence trading” popularized by John Meriwether’s Long-Term Capital Management and similar arbitrage shops. Convergence traders price financial instruments based on complex mathematical models, find two different instruments that are cheap and expensive on a relative basis and then buy one and sell the other, betting that the prices will, at some point, have to return to their proper level. The Renaissance approach requires that trades pay off in a limited, specified time frame. And Renaissance traders never override the models. Back in action, Medallion made its mark through rapid, short-term trading across futures markets. “I have one guy who has a Ph.D. in finance. We don’t hire people from business schools. We don’t hire people from Wall Street,” says Simons. “We hire people who have done good science.” “We have three criteria,” says Simons. “If it’s publicly traded, liquid and amenable to modeling, we trade it.” Unusual for a hedge fund, the heart of Renaissance is not its trading room an uncluttered room where a score of traders buy and sell around the clock but rather an auditorium with exposed beams that seats 100 and features biweekly science lectures. Last month a molecular biologist presented research on colon cancer. “When you hear someone talk about an interesting use of statistics it helps trigger your thinking,” says one Renaissance employee.

I remember a few years ago, sitting in the private office of one of the best trend following traders around (performance and assets), talking about this very issue with him: how does Simons really trade?

He was not buying the ‘short term’ public facade.

More on Billy Walters.

Casino math (PDF) may be the most important wisdom you can know to be a successful trend follower. In fact, I feature much of this thinking in my documentary film.