The Laws of Trading

A Trader's Guide to Better Decision-Making for Everyone

Agustin Lebron

• Publisher: Wiley
• Year: 2019
• Print ISBN: 9781119574217
• eBook ISBN: 9781119574200
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Every decision is a trade. Learn to think about the ones you should do — and the ones you shouldn't.

Trading books generally break down into two categories: the ones which claim to teach you how to make money trading, and the memoir-style books recounting scandals and bad behavior. But the former don't have profitable trades to teach; if they did they'd keep those trades to themselves. And the latter are frequently entertaining, but they don't leave you with much you can apply in your own life. The Laws of Trading is different.

All of our relationships and decisions involve trading at some level. This is a book aboutdecision-making through the lens of a professional prop trader. For years, behavioral and cognitive scientists have shown us how human decision-making is flawed and biased. But how do you learn to avoid these problems in day-to-day decisions where you have to react in real-time?What are the important things to think about and to act on? The world needs a book by a prop trader who has lived, breathed and taught trading for a living, drawing upon years of insights on the trading floor in real markets, good and bad, whether going sideways, crashing, or bubbling over. If you can master the decision-making skills needed to profitably trade in modern markets, you can master decision-making in all walks of life. This book will teach you exactly those skills.

• Introduces, develops, and applies one law per chapter, making it easy not only to remember useful concepts, but also to have them at the ready in any situation.
• Shows you how to find and think about the "special edge" of your organization, and yourself.
• Teaches you how to handle the interaction of people with artificially intelligent (AI) machines that make decisions, a skill that is rapidly becoming essential in the AI-driven economy of the future.
• Includes a "bonus" digital ancillary, anExcel spreadsheet with various worked examples that expand on the scenarios described in the book.

Do you need to make rational decisions in a competitive environment? Almost everyone does. This book will teach you the tools that let you do your job better.

CHAPTER 1
Motivation

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Know why you are doing a trade before you trade.

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Why Are You Trading?

David, a well-to-do dentist, is settling into his home office on a Friday morning. He usually takes Fridays off from work. In the morning, he likes to trade stocks and in the afternoon he plays golf. David has CNBC on the TV in the corner as he settles in to read the Wall Street Journal and FT Alphaville. He mostly likes to bet on quarterly corporate earnings announcements, usually by trading short-dated options.

David's wife, Rachel, comes into the home office:

Rachel:	“Going to pick up some things at the supermarket. Want anything? How are things going by the way?”
David:	“Good, earnings season is heating up. Got a good feeling about some of these picks I've made.”
Rachel:	“How have you been doing so far this earnings season?”
David:	“I made a couple of good calls yesterday. Decent. Nothing like that awesome streak from last year, but pretty good.”
Rachel:	“So you're making money?”
David:	“Look, there's a lot of variance so it's hard to say for sure. What I do know is that when I get in the zone, like I did those couple of weeks a year ago, I make all the correct calls. It's like Neo from the Matrix.”
Rachel:	“Neo traded options?”
David:	“No he didn't. But when he got in the groove, time slowed down and he couldn't miss. That's how it feels when you're trading and you're feeling it. Like you almost can't lose.”
Rachel:	“Can't lose? I thought there was a lot of variance.”
David:	“Ah, you just don't get trading…”

Shouldn't This Chapter Be Short?

If people were perfectly rational, profit-maximizing, highly capitalized¹ entities, this chapter would be quite short. “Why are you trading?” To make money. But the real world is more complicated.

Even if we were perfectly rational profit maximizers, there would still be very good reasons to trade other than “to make money.” For example, when you buy home insurance you know (and in fact hope) that the expected value² of that transaction is negative. However, you buy the insurance anyway because it decreases the risk of a huge loss if your home ever goes up in flames. You are said to be hedging your home-loss risk, and it's perfectly rational to do so. When we cover this idea in detail in Chapter 3, you will learn that the quantity you want to maximize is not profit but utility, a sort of risk-adjusted notion of wealth. So, are people who trade in financial markets motivated by utility?

In a trivial sense, anyone can answer yes after the fact. Much like a child who trips and falls and says, “I meant to do that,” utility is what we claim it is. But humans are complicated, and perceived utility comes in many forms that differ from actual utility. In fact, as described in great detail in various recent works (especially Daniel Kahneman's Thinking Fast and Slow), humans are an unreconstructed bag of cognitive biases that cloud our judgment of utility. There is a whole field of social science called behavioral economics that seeks to identify and understand all the ways in which we fail to behave as perfectly rational decision makers. And it turns out that by and large we humans are quite poor decision makers:

• We underestimate small probabilities sometimes (the chance of getting hung up in traffic and arriving late to an appointment) and overestimate them other times (the chance of dying in a plane crash).
• We consistently overestimate our knowledge (a cognitive blind spot known as the Dunning-Kruger effect) and abilities (well over half of surveyed people think they're better-than-average drivers).
• When suitably framed, we consistently say that A and B occurring is somehow more likely than A only occurring. When we do this, we're violating a basic principle of logic without even noticing it.³

Many of our motivations, our sources of utility, aren't even about profit or risk-adjusted profit. This is obviously true in general, but it's even true within the narrower world of trading. We really do need to examine these trading motivations in detail, since they surface most clearly in the world of financial markets but they can also appear in other trading-like contexts. This fact alone should make the following classification of human foibles useful even if you've never dabbled in financial markets. Let's take a tour of the irrationality that characterizes the human mind and the sometimes-odd places it finds utility.

Greed and Fear

Greed and fear are the famous emotions of trading, and of financial markets in general. Recall Gordon Gecko in the movie Wall Street, or the Duke brothers in Trading Places, and how they were motivated by greed and fear. Many books have been written about these emotions, and how they relate to trading: how to mitigate their effects, how to use these emotions positively, how the induced herd-like behaviors affect the markets themselves, and many other aspects. There are books and articles that purport to teach amateurs how to “think like a pro” with respect to these subjects, and hence trade profitably. Without casting aspersions on specific works, almost all of these books are worse than worthless: they focus you on the wrong thing.

The plain fact is that almost no professional traders think of their work in terms of greed and fear. The profitable trades they've developed, the systems they've built to trade them, and the social environment in which they work are all designed to make these emotions fade into the background. In a highly underappreciated paper from over a decade ago (Lo, Repin, & Steenbarger, 2005), the authors study a population of traders, and correlate their results to their emotional states and personality types. The results show clearly that the traders whose emotional reactions were the most intense were the least-successful ones. It didn't matter whether the emotions were positive or negative, it was the fact that these emotions weren't being modulated. Interestingly, the paper also shows that there was no apparent correlation between personality type and success at trading. Thus, the stereotype of the loud, hard-charging, aggressive trader is not borne out in the data. All personality types can be successful, in principle.

Other studies of the emotional reactions to risk taking are found in The Hour Between Dog and Wolf (Coates, 2013). The story is similar: to the extent that trading and risk taking cause emotional reactions, those reactions generally obscure clear thinking in those high-pressure situations. This is not to say, however, that there is no place for emotion in trading. It's that the specific emotional reactions need to be trained, just like every other aspect of your approach, and greed and fear just aren't terribly useful.

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In my own case, I know that I tend more toward the fear end of the spectrum. When I was first starting out in trading, I didn't have any real trading authority. I did what senior traders told me to do, learning as I went. But eventually, I got the opportunity to make my first real trading decisions. That first time I decided to buy those upside call options in Deutsche Bank, I knew intellectually that it was a good decision. But that didn't entirely inoculate me from the fear that I had either misjudged the situation or that the trade would go against me by random luck. There isn't much you can do about that latter situation, but tell that to your amygdala (the grey matter inside your head that experiences emotions) while it's happening. Over time, as I got feedback and validation that I was making good decisions, I managed to retrain my emotional reactions into more useful forms.

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Boredom

Greed and fear are, in the world of trading, two extremes of the same emotional continuum. They are emotions related to high activity: winning or losing. Something's happening. But along another axis, we know that the level of activity in financial markets varies greatly. And most of the time, in modern financial markets, not much of anything is happening.

Quick, go Google “trading boredom.” If your results are anything like mine, the top few results will be articles on amateur trading blogs and websites that try to give people tips on avoiding boredom. Evidently, this is a common problem among amateur traders, as well it should be. People frequently claim they're getting into trading because they want to make money, but in fact the reason is much closer to: “it gives me something to do,” like our friend David at the beginning of the chapter. And often, there really isn't anything to do. The average amateur trader, no matter how prepared or sharp, is not going to find very many obviously profitable trades to do (assuming they're not fooling themselves). The result is long stretches of doing nothing, which is certainly not w...

Table of contents

• Cover
• Table of Contents
• Acknowledgments
• Foreword by Aaron Brown
• Introduction
• CHAPTER 1: Motivation
• CHAPTER 2: Adverse Selection
• CHAPTER 3: Risk
• CHAPTER 4: Liquidity
• CHAPTER 5: Edge
• CHAPTER 6: Models
• CHAPTER 7: Costs and Capacity
• CHAPTER 8: Possibility
• CHAPTER 9: Alignment
• CHAPTER 10: Technology
• CHAPTER 11: Adaptation
• Index
• End User License Agreement