Book notes – Way of the Turtle – II

September 7, 2007

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 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

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