The 5 Fundamental Truths of Trading
"Anything Can Happen, at Anytime." -Mark Douglas
As a trader, the only way you can win is when you consistently have the odds in your favor. However, as humans, we are prone to cognitive biases and other errors that diminish our ability to heed accurate results. Successful traders understand the difference between probability, and historical probability. Despite Every trade has a 50/50 chance of being successful; that's the bottom line. However, if you take an edge, and then assess it's performance over a given number of trades, then you can adequately judge it's validity.
To be frank, P/L is not a good indication of sound decision making - to associate these factors (outcome and good decision making) is called resulting. The problem with this, however, is that A) luck is a factor, and can create false positives - otherwise known as a type I error, and B) you can lose, and never make a mistake (a false negative, or type II error). If you were to start changing your strategy, or miss mistakes because of resulting, you might as well be trying to measure a the yards in a football field using a meter-stick.
Douglas insists that the pragmatic way to develop a trading strategy, is to develop concrete-plan, in which you will execute the same trade (to the best of your ability, so as to limit the number of variables) over a given sample size (usually at least 20 trades). Only after performing a valid sample size can you effectively say whether or not a given strategy is effective, but if you judge it's validity on a trade-by-trade basis as it only has a 50/50 chance (whereas your strategy could have a 58% probability over time). For more info on this, please read "Trading in the Zone" - available in the Trading Journals store!
Gary Dayton also talks about the numerous biases and heuristics in his book, "Trade Mindfully: Achieve Your Optimum Trading Performance with Mindfulness and Cutting-Edge Psychology." He talks about heuristics, which are essentially mental shortcuts that people employ during complex or difficult decisions, or an "abbreviated rule-set," to aid in decision making. In Dayton's words, "when people make decisions under conditions of risk and uncertainty, they have a strong tendency to abandon careful rational analysis and, instead, apply heuristics and other cognitive short cuts. This often produces predictable errors and poor outcomes." For instance, the representativeness heuristic. Essentially, he cites the fallacy of judging the probable outcome of one event, based on the outcome of previous event that was similar. Take the ascending triangle pattern, for instance:
For instance, this is what we've been taught is supposed to happen, with ascending triangles:
However, in looking at this pattern, if you assume that this trade will go in your direction (just because it's of a particular pattern), you're falling victim to the representativeness heuristic; ascending triangles just have a historical probability of playing out, over a certain number of trades:
As you can see, in the failed ascending triangle, the market failed to break through the previous swing-high, breaking below the trend line, and engaging a stop-run when everyone who got long during that period was stopped out.
Confirmation Bias, or the tendency to interpret information in a way that conforms to your beliefs is another fallacy that we [as humans] are prone to. In fact, Annie Duke states that people that have high IQ's are more likely to fall victim to confirmation bias because they are very intelligent, and therefore have an easier time spinning the data to fit their narrative. In the words of a personal friend of mine, "See what you see, not what you want to see," and I highly recommend employing the methods expressed by Annie Duke (see our video about "Trading in Bets!"), in forming a truth-seeking group, to vet your decision making process and uncover your cognitive biases!
All Dayton, Duke and Douglas (I swear that wasn't intentional) are trying to say is that you can't judge the validity of a trade on a trade-by-trade basis. It's important that we maintain healthy skepticism when going through the decision making process, and make a commitment to accuracy in vetting our decision making process.