Hotch's Trading Thoughts: From First Principles

Firstly, I'm not recommending anything in this thread. It's really just somewhere to keep my thoughts as my head gets busy with all my personalities. It might come up with some Spainish89-style conclusions, but it's theoretical, not pratical...yet

It is quite likely it will just end up as a lot of nonsense, apologies.

I don't really know how to explain the first principle thought process, I guess it's really just taking everything back to basics and working up. I found it very useful in maths exams as it meant I didn't have to remember anything as long as I could rely on myself to prove everything in time to answer the questions before I ran out of time. I have really come around to this type of thinking, I find it calming, and I generally come to logical conclusions which work out for the best. It keeps applying itself to more aspects of my life, so why not trading?

I'll start with Money Management (might not even get onto anything else)

Assumptions:

Not normally part of first principles thinking really but we're all after different things, so I'll go ahead with these...

Gut instinct isn't useful.
A salary doesn't need to be drawn.
Liquidity isn't an issue.
You are awesome and can trade without having to waste time working stuff out (go go mechanical systems).
A market is moving at any one time.
Your aim is to increase your capital as fast as possible....without excessive loss to the account.

Of course, the first thing which springs to mind is "define excessive".

This of course can only really be defined personally, but for now, let's assume excessive loss, is the whole account. There are 2 reasons why I think this is a good place to start.

1-If you lose all your account, you can't continue to trade...there can't be a more excessive loss then that.
2-It's simpler to start here, and from there we can then apply what we define as excessive.

So you want to aim to increase the account as quickly as possible without blowing the account.

Firstly it's obvious (to me), that all your money should be invested at one time or another. If you're not in the market you're not making money. There are few reasons for not having money in the market, none which seem logical.

1- Saving it for a good opportunity
You can withdraw your money from the market at any moment to invest in an opportunity which is better.
2-Risk
The only reason you wouldn't have money in the market due to risk is that if you think you're going to lose it if you put it in, either then your expectancy is negative and you shouldn't be trading anyway, or you place the trade on the other side of the fence.

So you want to put all your money in the market. Now this is where I find the first real dispute in adjectives.

To increase capital as fast as possible, logic would suggest you invest all your money into whatever has the greatest value of the following formula (commission etc):

V=expectancy/time to close trade (I think...)

Of course, unless your chance of winning is 100%, this doesn't agree much with the excessive risk objective.

Obviously there is a middle ground, whether there is a logical (mathematical) way to determine this, I am currently unsure...

I'm going to leave it here for now, I haven't really got very far at all, apologies. Say what you will, It may well appear to be very stupid, but I'll keep at it for a bit before dismissing it, first principles is (normally) the nuts.

Happy trading


...OK

This might not be the logical route (not really first principles then, but it's what has occurred to me).

Obviously, if you take one trade, it will be the one with the highest value of V, if you take 2, it will be the top 2, etc. So the average value of V will move down as the number of trades increases, that is to say that as you diversify your risk (assuming the portfolio is varied etc, this needs to be looked into later), the average value of your trades decreases. We can plot this on a graph, and (possibly) the best course is to maximise the area A. Thoughts?

Of course the scale does have an effect (how far do you weight number of trades against value...

In theory, I guess the graph has the axes as asymptotes, not sure if that helps, it's getting too late for this though.

Hotch said:

I don't really know how to explain the first principle thought process, I guess it's really just taking everything back to basics and working up.

Click to expand...

I'll break the silence.... Not to comment on the content of the post but on the process. I think this is a great and refreshing approach. There is a good deal of "received wisdom" when it comes to trading and a lot of it is untrue (probably because it is received from people who are unprofitable and more interested in their egos than their method!).

You need some knowledge as a framework to build upon but otherwise just go for it and see where it takes you. If it is nonsense, at least it is your own brave nonsense.

Ben

RedGreenBen said:

If it is nonsense, at least it is your own brave nonsense.

Click to expand...

Thanks. Even if I come up with nonsense, I might trade it anyway (real money), for reasons best expressed (like many things) with a demotivaional poster...

Chapter 2: Risk of Ruin

So last time I decided, that I wanted to have all my trading capital at risk in the market, and that I would want to have multiple positions to lessen risk, but not too many that my expectation would be lowered "too much".

One thing I've seen on this forum, as you see many places, is people just accepting of boundaries, without question. This is really dumb. You ask people how much they risk on a trade and they instantly pipe back "2%", you ask them why, and they're say something about risk, they might even say risk of ruin, but the vast majority don't really know why, it's just generally accepted as a good idea.

What is really happening (or should be) is a simple risk or ruin calculation. It's personal for each individual.

You decide how much of your account you can afford to lose, and how often you want it to happen. Then from your win rate, and risk to reward ratio, you can figure out how much of your capital you want to trade at a time. I doubt many on this forum have actually bothered to do these calculations.

Sure, 2% is probably safe, but if you suddenly double the win rate of your strategy, do you want all that to go into making it safer, you were comfortable before weren't you? Why not increase the risk? (quote of the day!)

I'm sure there is more I had to say, but I'll leave it at that for now.