I have been reading the book – Way of the turtle for the past few days and have found it to be a good book. It is a book on trading. I posted my notes on the first two chapters earlier.

Notes on 3rd, 4th and 5th chapters follow –

The third chapter refers to the risk of ruin. This is risk a trader faces that several of his trades will go against him and he could lose his entire capital. The way to manage this risk is via Money management. This involves putting the position in small chunks called as units which are sized based on the type of the market, volatility measure of the market etc (please refer to the book for more details).

The third chapter refers to four key points

– Trade with an edge: Find a trading strategy which can produce positive returns over the long run as it has a positive expectation (see an earlier post on edge, kelly’s formulae etc here)
– Manage risk: Control risk via money management discussed earlier
– Be consistent: execute plan consistently to achieve the positive expectation of the system.
– Keep it simple

All the above points are equally valid for an investor as it is for a trader.

The fourth chapter focuses on thinking in the present and aviod thinking of the future. Successful traders do not attempt predict the future. They do not care about being right, only about making money. A key point is that good traders are also wrong a lot of times. However they do not beat themselves over it. They are focussed on sticking to a plan and trading well and not worrying about the success of each trade or do not look at each trade as a validation of their intelligence.

One of the biases namely recency baises can impact a trader severely, especially if he is on a losing streak. People have a tendency to overwiegh recent data. Recency bias results in a trader over wieghing recent performance, especially bad performance and the trader may end up abondoning a successful system. The way to avoid this bais is to focus on probabilities and to know that every system has a certain odd of failure (A certain number of trades will go wrong). However by focussing on the process than the outcome and being confident that the system works well in the long run, one can remain rational and continue with a successful system.

The fifth chapter discusses about the concept of edge in more detail. The chapter introduces various concepts such as MAE (maximum adverse excursion – loss over the time frame) and MFE (maximum favourable execursion – gain over a time frame). The E-ratio (edge) is ratio of MFE/MAE adjusted for volatility. This ratio can calculated for various duration such as 10 days, 50 days etc.

To find an edge, you need to locate entry points and exit points where there is greater than normal probability that the market will move in particular direction within the desired time frame. The various components that make an edge for a system comprises

– portfolio selection : alogrithms which markets are valid for trading on any specific day
– Entry signals : alogrithms that determine when to buy or sell to enter a trade
– Exit signal : alogrithms that determine when to buy or sell to exit a trade

I referred in my previous post about a book on trading – Way of the turtle which I have been reading for the past few days. Now why should a guy who displays a mental block against trading, read a book on the topic? The short answer is to challenge my own biases against trading.

I can definitely say that this is a good book and anyone wanting to learn about trading or wanting to evaluate a trading system (in a book or being sold by someone) should read this book. What follows over this and the next few posts is my own summary (not review) of the book with my own thoughts and comments (which I cannot resist putting 🙂 )

The book is written by curtis faith who was one of the turtles (traders) recruited by richard dennis and william eckhardt as a part of an experiment that trading can be taught. The author was one of the original recruits (and probably one of the most successful) who made more than 30 million for Richard.

The book describes the difference between an investor and a trader. An investor buys stocks, but is really buying an underlying business. A trader in contrast is concerned only about price and is essentially buying and selling risk. The second chapter of the books talks of the turtle mind, which I think is equally relevant for an investor.

As we all know that markets are populated by individuals who are driven by fear, greed and all other cognitive biases, which create opportunities for a trader. The book refers to various biases such as loss aversion – higher preference to avoid losses over gains, sunk cost effects – tendency to treat money that has already been committed as more valuable than money to be spent in the future, disposition effect – tendency to lock in gains and ride losses, outcome bias – tendency to judge a decision by the outcome than by the quality of the decision at the time it was made and several other biases such as recency biases, anchoring etc.

The second chapter describes each of these biases in detail and how it affects a trader. The chapter continues with various trading styles such as trend following, counter-trend trading, swing trading and day trading.

One the key points I realised from the initial chapter was that each of these trading styles are valid for specific types of market. Curtis refers to various markets such as stable and quiet, stable and volatile, trending and quiet and trending and volatile. For example, trend followers love markets that are trending and quiet where they can make more money than a volatile market which is more punishing to trend followers. In contrast counter-trend traders love markets that are stable and volatile.

Another key learning for me in the chapter – successful traders never try to predict the market direction. Instead they look for indications that a market is in a particular state and trade accordingly.

I will be posting the rest of my notes over the next few posts. You can find the author’s blog here.