Two things stand out from college. Okay, maybe three, but only two are printable. First was the professor who said, “History is philosophy teaching by examples.” I liked that. A person’s actions are dictated by their belief system. To some extent, people’s belief systems are dictated by the times they live in. It wasn’t that long ago when the earth was flat and “night gases” caused malaria. Since everyone knew those were “the facts,” they responded accordingly. The second was the professor who said, “There are lies, damn lies, and then there are statistics.”
An example? In the 1960s, “nine out of ten doctors agreed that Camels were the best cigarette.” Damn lies and the philosophy of the times all rolled into one.
As humans, our brain searches for patterns and interprets them for our own survival. In the 1500’s, that led us to believe that we were the center of the universe. In 1967, that may have led us to smoke Camels. In 2016, what we know to be “facts” today will be viewed as naive and childish in a few decades, let alone 500 years.
Throughout all of recorded history, however, there is one consistency: Winning streaks and the impact it has on the people or society experiencing that streak. Everyone’s instinct, from Julius Caesar to Cam Newton, is to be overconfident and to read way too much into their own success. The more overconfident they get, the harder they fall when the winning streak ends. Because it always does.
As it relates to trading, winning streaks are usually followed by the nastiest of losses. The smarter we think we are, the further back the market is pulling its fist, readying the punch. “I’m a genius,” we think. “I should start trading much bigger size.” Riding a winning streak is like riding a horse. When it gets tired, resist the urge to gallop. Just get off the damn horse.
But is it random? Let’s say you have a setup that has a 75% win ratio over 100 trades. Yes, it would be nice if each losing trade was then offset by 3 winning trades. But, of course, the distribution of winning and losing trades is completely random.
Take tossing a coin, where the odds of it coming up heads or tails is 50%. Yet, flip that coin 100 times in a row, and you have a 75% chance of seeing a streak of 6 or more heads/tails in a row. And a 10% chance of seeing a streak of 10 or more in a row. That is random. But we humans will latch onto that streak of 6 or more and chalk it up to our own genius.
In trading, our “side” of the coin has an increased weight of 75% in our favor, due to our edge. So the winning streaks over 100 trades can last much longer than a coin flip, especially if we are selling spreads. And our brain’s need for controlling the environment will give weighted meaning to these winning streaks. And there should be none. After 10 winning trades, we are not smarter. We haven’t discovered the Holy Grail. It was random.
And the other side of this? We will also give weighted meaning to our losing streaks. When there should be none. We aren’t losing our minds. We aren’t reading the markets wrong. It was random. Forgive yourself and move on.
At the end of the day, we know we have an edge, but we must keep in mind the strong influence of chance. If randomness has anything to teach us, it’s to be weary in certainty.
See more of John’s daily analysis HERE.