Removing Bad Trades from a Strategy

A listener asks how he can remove 30% of the trades he's taking in his trading strategy that he knows are hurting his results.

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Creators & Guests

Host

Dave Mabe

Host

Michael Nauss

What is Line Your Own Pockets?

A weekly show for systematic traders who want to make more money from their trading strategies.

Michael: 00:01

Alright, everyone. Welcome back to another episode of Line Your Own Pockets. In this episode, we're actually ask answering a viewer question in which someone got emailed in to Dave. I'll get him to explain it further, but I just wanted to say we read everything you guys are posting. You know, if you have questions, ask away.

Michael: 00:18

If it's a question that we think is good for the podcast, we'll bring it up. You know, the the feedback I'm getting is phenomenal from accounts that I've never really interacted before saying, hey, love your podcast. I think I just tagged you on Twitter before we got started, Dave, with someone else with some other topics. So, we love the interaction, so make sure you're sending it. And, Dave, what was this particular question that you wanted to bring up?

Dave: 00:42

Yeah. So, this was some somebody that signed up from a free newsletter. This is the email newsletter that comes out a couple times a week. And in the welcome email to that, I ask a question. I say, you know, what is the biggest obstacle right now in your trading?

Dave: 00:57

And I often get some very thoughtful responses, and very often I respond to them. And this was a particularly good topic that I thought we should bring up on the pod here. This was from Raj. He gave me permission to use his name, on the air here.

Michael: 01:14

Mhmm.

Dave: 01:15

And he said he's been a breakeven trader for 2 years, been trading for 2 years. And he realizes now that looking back on his trades, that he's taking 30% too many trades. And he can he thinks he can identify those 30%. And the question was, how can I stop taking them? I I he's very tempted and just continues to take the trades like a fear of missing out

Michael: 01:52

Mhmm.

Dave: 01:52

Or something. So, like, his question was, how can I stop taking these trades?

Michael: 01:58

Well, I think the first thing you have to say, someone says they're breakeven traders. Congratulations. Right? I think all of a sudden, you're you're way above 80, 90% of the people out there. And then also congratulations on on doing some work to identify problems.

Michael: 02:15

Yeah. And I think that's already you're already in the in the top 10, 20% of of everyone that tries from there. This one's gonna be interested, and I I definitely think we're gonna find some some good ways to do this because it seems from what I'm hearing, just to describe it to myself and the audience, make sure I'm getting it, is this is a pure kind of psychological problem that he's having. So he's a little bit too quick on the trigger. He's, you know, that whole FOMO of I should take this trade because what if this great thing happens and I miss out and that's going to be painful, which, you know, I'm sure we'll get into.

Michael: 02:52

But all of trading emotional problems are all about pain avoidance in some way. Right? You're you're saying, hey, I I want to avoid the pain of either losing. That's why people, I think, tighten up stops too quick or or something like that. Or you're trying to avoid the pain of, you know, I wanna buy this thing at 10.

Michael: 03:09

What if it goes to 12? And and I didn't get in. Did he describe at all how he had figured out that this was a problem for him? Because I think that might be a good place to start.

Dave: 03:19

Yeah. He so I went back and forth with him over email here and gave him some suggestions that I'll that we should discuss here.

Michael: 03:27

Mhmm.

Dave: 03:29

So my first thought was well, I had a couple impressions. One is it's pretty sophisticated to be able to come up with a number like this, and to speak about that credibly. So it's it's really gave me a good impression that this guy has a really good system in place for keeping track of his trades. He's able to go back and identify 30 I mean, to come up with a number as specific as 30%. That's it's impressive.

Dave: 04:00

So I could say I can tell that he already has a process in place to be able to do this. So what I suggested to him so my next question was, of course, it's easy in hindsight to identify the 30%. The real challenge is, how can you know and and identify that 30% before you take the trade? So that's the next test I gave him is, how can we make sure that you aren't fooling yourself here and can identify those before you take the trade?

Michael: 04:43

It's it's interesting because, there's an old quote. I think it might be Ralph Algonquin who is for those who don't know, he's the godfather of technical analysis. They call him he created the CMT. And one of his favorite quotes that I love is that, you know, technical analysis doesn't give you all the answers, but it helps you ask the right questions. And I that's feels like a lot of what this, this viewer and this this user is doing.

Michael: 05:10

At the very least, it's asking the right questions, and and what you're giving him back is more questions to ask. And I think that's a lot of the the benefit of being a systematic trader with tools like back testers and and things like this available is he's not coming to you and say, hey. I'm losing money. Help. He's saying I have this very specific problem, and I've identified this very specific problem.

Michael: 05:32

You just went back to him and said, okay, but you have to be even more specific. Right? So you're saying 30% of the trades you are making money on, and that's fine. That's all well and good, But you need to drill in even further and try to find some numerical or quantitative or indicator or whatever it is that helps identify what those trades are. Because only then in the moment, in the heat of the moment, can you filter that out either if you're an automatic trader by just not having your system take those trades anymore, or if you're someone who's scanning the market in the real time saying, I don't wanna see these trades anymore.

Michael: 06:10

Whatever it is that that makes perfect sense. Now that seems like a bit of a daunting task without knowing exactly what to look for. So when he's going through this process, what would you suggest being pain points that you could look at? So if I if I identified and say you have no more information, I'm saying about 30% of my trades, I think, are just complete off the cup rogue, rogue trades. How would you then help me drill in and say, you know, what what are some things or indicators or something you would have me look at to to dig in a little deeper?

Dave: 06:44

Yeah. So, yeah, you're right. It's a difficult problem. And part of the problem is, you know, it's easy to go back and look at, oh, here's my least profitable trades. I'm not

Michael: 06:56

at

Dave: 06:56

least figure out how to not take those. When really, in reality, you're gonna be coming up with a rule that does exclude some profitable trades.

Michael: 07:04

Yep. Right?

Dave: 07:05

And that's the hard part. Figuring out the distribution of, you know, the the the pocket of trades, some of it are which are still gonna be good and you're gonna wish you'd have taken. But coming up with a rule that makes sense that can get rid of the worst 30% of your trades using some criteria. So the solution or the plan I came up with for him was something that any actually, any trader could use. You you wouldn't have to be systematic necessarily or, you know, trading automatically to benefit from this.

Dave: 07:42

So here's here's what I suggested to him. You should always be journaling your trades. So he I could tell he was journaling his trades. But afterwards, at the in your daily review as you go and log your trades, assign a specific tag that, for this set of trades that you believe, are poor compared to the rest of them. So, you know, grade b or, you know, suboptimal, some tag that you can use to different you know, just to group them in your journal.

Dave: 08:22

And so he as our interaction went on, it was clear that he did have a criteria. He he could identify them before entering the trade, but he just couldn't not take them because I think because of what we were saying before is some of these are gonna be profitable, and he doesn't really wanna miss out on those. Mhmm. So but he I could tell just from what he was saying that he knew that he would improve if he were to stop taking these trades, and he just couldn't do it.

Michael: 09:03

So Yeah. That becomes, I think, a little bit harder because now you're talking not so much about systematizing, you know, the the the trade not to take, but you have to somehow change, I guess, your environment or you have to systematize kind of the way you're looking at it. So this is and I think you mentioned this before, Atomic Habits, the the book, the guy talks about all the time that changing if this is a compulsion, for lack of a better word, that becomes very you know, without seeing a psychiatrist, that becomes very hard to deal with. What you have to do in some ways, you have to kind of change your, your environment so that you're less likely to do that thing. So the I the perfect example, I think, would be if you're eating too much sugar at night, you know, you take the chocolate bars and they're not in your house.

Michael: 09:51

Right? So I I'm gonna guess that that's kind of where you went next is you have to say, okay. You know, I'm not gonna put you on the on the couch like doctor Phil and have a, you know, that kind of conversation. What can you do from a technology point of view or from a systematic point of view that's gonna limit this, compulsion or this ability to do this thing that you know is harmful?

Dave: 10:13

Well, so so here's what I suggested, and here's what what I have suggested to traders for a long time, and it and it really gets people motivated when they see the data this way. So once you assign the tag and you're doing that regularly, you you can go back retroactively and assign the tag. Once you do that, you can run a report in your journal that shows all the trades and then just the ones assigned with that tag. Okay. And all of a sudden, it becomes really clear how bad these these set of trades is.

Dave: 10:52

And there's something about seeing it over a course of time, you know, through an equity curve compared to the rest of the trades that really gets people motivated. Like, there's no there's no sweeping it under under the rug at that point. Here it is in black and white exactly what you're doing.

Michael: 11:09

Well, yeah, you're

Dave: 11:10

just solving That's

Michael: 11:11

You're just solving really motoring. There's a dollar value now. Right? You you can now say, you know, my breakeven trades, maybe I would have made $50 this year if I had cut those out. And then that, I think, does a lot to to sink it in people's heads.

Michael: 11:26

Like, jeez, you know, 50 grand. That would be I could I could I could have done this or I could do this or I could, you know, work less or or, you know, buy more things or whatever their motivation for trading is. So I totally agree. As soon as you you see that as a direct dollar figure, it it's much easier than saying, oh, you know, I broke even today, and then maybe I would have made some money if I if I didn't take that rogue trade as opposed to the difference between, you know, me working full time in this job I don't like versus working part time in this job I don't like is this one trade. I think it that then does become, again, it hits home.

Michael: 12:03

It's more real. Again, just to continue down the the diet analogy, I'm sure you've seen, like, the posters where they they show the drink, and then they show how much sugar cubes are in it. And, you know, when you see it broken out like that, it hits a little bit harder than just looking at a, oh, is there 50 grams of sugar in a in a Coke? So has he done that? Was it a a very substantial difference?

Dave: 12:27

He has done that, and I I haven't heard the results yet. Still some time needs to go by before he he's gonna report back. Mhmm. But, yeah, I think this will he he seemed really excited with the plan, and he it I get the sense that it's gonna work for him. The other thing this does well, there's a couple other things it does.

Dave: 12:49

One, this is great for somebody who's not quite trading systematically yet, but this is a path toward that. And just by even retroactively assigning a tag in your journal for trades, that does give you a path toward being able to assign that tag in your head before you take the trade. And it it sort of bridges that gap because it it is hard to, like I said, it's hard to do retroactively. It's easy to do retroactively, but it's hard to do in the moment. Some and like I said, some traders feel like they can do that in real time.

Dave: 13:32

But when it comes down to it and you're in the moment, it's they're sort of fooling their self, and they need to do a little bit more work to be able to do that. And this gives you a path toward that.

Michael: 13:45

Well and it stops the, the self abuse cycle that I myself, I know a lot of traders have been into where, you know, you're looking at the end of the day and you're saying, why the hell did I do that? Right. What, you know, this thing I didn't and you're kind of beating yourself up and then you go in the next day and you haven't really addressed the underlying issue or concern. So then you end up maybe not the next day or, you know, a couple weeks later or a month later, you end up doing the same thing. And without addressing what this underlying issue or this underlying concern and and figuring out a way to kind of change your environment or or get this out of your out of your life in some way.

Michael: 14:24

Yeah. That cycle will just will just repeat ad infinitum. Right? I'm sure there's traders who have been doing this for 20 years who are still breakeven. And if they could only just get that one thing that's making them more breakeven out of the way and do so in a way that they can do consistently, that's the difference.

Michael: 14:42

Because quite often, it's not about adding a new trading style or strategy, which I think a lot of people fall in the trap of. It's about removing just enough to get that strategy over the hump. Right? Because we only need a small edge that we exploit over a long period of time in order to in order to be profitable in this game.

Dave: 15:01

Yeah. And, you know, once you are able to remove these trades, all of a sudden, the total number of trades you're taking at that point, sure, it's gonna be smaller.

Michael: 15:14

Mhmm.

Dave: 15:14

But those trades are gonna have a much higher average profit just by the way the math works out. And that is gonna give you a lot of confidence going forward. It's it's it's like a completely different strategy. Now one thing the the thing I really love about this, because the next phase after he gets this in place is an even more powerful way to improve a strategy. And that is it gets you thinking about in what ways are, you know, what things are predictive for profit in this strategy.

Dave: 15:54

It gets you on the path of, figuring out the next step, which would be, which trade should I be taking with more size

Michael: 16:04

Mhmm.

Dave: 16:05

Instead of less size? And, you know, sometimes I'll hear people say, oh, you know, I can't possibly you know, everything that's in my system, I'm taking with the same size. There's no way I could possibly find some that are better than others. They're all the same. Like, well, that can't possibly be true because there's a whole bunch of trades that you're taking essentially with 0 size.

Dave: 16:29

Right? Like, this 30%. Once he gets through and and creates a role for these, you're create you're you're trading those you know, trading them with size 0. That it's it's the exact same thing as finding other trades in the system to trade with bigger size.

Michael: 16:46

Yeah. And I I think I think to bring in a, more concrete example for for the listeners is that, let's say, for example, this user found out that he was chasing stocks that were up too much and and applying a simple momentum filter and RSI or stochastic, and just avoiding trades that were overbought ended up improving the system dramatically. What Dave is saying, well, now that you know that this momentum indicator has some effect and can remove some things, well, now it's time to play with that number. Right? You know, maybe an RSI above 80, If you just didn't take trades with that, all of a sudden, these 30% of trades are gone.

Michael: 17:28

Well, that just begs the question. What about 70? What about 60? What about 50? Right?

Michael: 17:32

Is there an area in which you can cut down your trades dramatically? Maybe apply more risk to trades and then go from there or some hybrid. Maybe when the RSI is 70, you still have an edge, but it's smaller. And then when the RSI is 60, you have an edge, but it's bigger. So when you're going through your trades you're using this and again just indicator I just pulled out of thin air but you're using this metric to now say I know this trade has a higher probability because it's less overbought than than this so now I'm gonna I'm gonna size up here I'm gonna Maybe I am still going to take those other trades, but I'm gonna take them lower and and things like this.

Michael: 18:07

So as soon as you add that numeric value in, well, you know, it it just it it creates the kind of, the curiosity bug that I think me and Dave really like from this trading where you're like, okay. I found something that has an effect. Now let's test the effect through its extremes. Let's go, you know, up and down the curve and and see what will will happen if I change this, this, this, and this. And then the hope is eventually you get, like, a number that's really, really compelling.

Michael: 18:32

If you're saying, hey, I can, you know, I can filter half my trades out and have way bigger of an edge. Well, that's great. So now I just size up more into that edge, and and I'll be better in the long run.

Dave: 18:43

Yeah. There's lots of different ways to improve with trading strategy, and, I'm imagining, well, we're gonna have several episodes about different ways to do it. But this is a common one. And what traders don't realize is they're so close to being able to improve their strategy in a lot of different ways. So, you know, you can overtrade a strategy.

Dave: 19:15

You can undertrade a strategy. Mhmm. There's lots of different ways to improve it, and it's very you know, probably the most common thing I see is exactly what Raj is going through here, taking too many trades in their strategy and figuring out and and the the potential is, you know, getting rid of 30% of your trades. This is not an uncommon problem. And a lot of traders that I work with, they don't even realize that it's going on for them.

Michael: 19:44

The the other thing that keeps in mind too is is say because I've I've heard this before where, you know, I deal with traders who are trading too often. They say, well, you know, if I limit, maybe they're only taking 3 to 4 trades a day and say, hey, if I limit that to 1 trade a day over time, my returns are going to be way more sporadic because win streak and loss streaks may end up taking longer. And the idea that I always give them is that if you refine a strategy down till it's a very good strategy and you find that there's long periods of time where you're not doing anything, that just you just opened up a world where you can now build another strategy to to fill those times. Right. So just because you may refine a system down to what looks you know, even a little anemic by the amount of frequency you're putting into it, it doesn't mean you're done right now.

Michael: 20:31

It's okay. Now I have a whole bunch of free capital that I was throwing into these worthless trades. Well, now what can I do with that capital? Can I build another strategy altogether? Is there some tweaks I can have to my current strategy to let in more trades?

Michael: 20:45

That's a good problem to have both being, I think, maxed out on buying power is a good problem to have and being underutilized and buying power is a good time for that part to have because as soon as you get some level of consistency, if you're telling me that you're consistent with a low amount of buying power and there's not really room to size up in that strategy, that's fine. Just time to go take that walk in the woods and think of something else that you can do with this this unutilized power that you have.

Dave: 21:12

Yeah. You're totally right. I mean, that's that's that's the big promise of this is, you know, efficient use of buying power and, you know, figuring out what that is given your given the buying power you have and what what strategies you trade, how many trades you're taking, what size. I mean, there's just so many ways to improve your trading and a strategy. There's it's just you just need to think about it in the right way and, you know, look at it as a as a really big optimization problem.

Michael: 21:45

Yeah. And I'm I'm one that I I really do love the multi strategy approach. For for my kind of longer term swing trading investing. It's for me, the thing that's changed, the the most in my trading is instead of trying to master a very specific strategy, being able to back test over a long period of time and, you know, as a longer term trader saying, hey. Buying breakouts doesn't work in a bear market.

Michael: 22:09

So if I have a a system that turns that strategy to crack cash in a bear market, well, now I've got all this cash freed up. So maybe I do some revision to the mean trading. Maybe I do some shorter term trading, things like this that end up smoothing out that equity curve. And I think that's huge for traders because when you're when you're stuck in the unprofitability, you're very, very focused on refining the strategy you have. And I think that's perfectly right.

Michael: 22:33

But you need to always keep in mind that when you get this strategy to a suitable place, again, it doesn't mean you're done. Right? There's something else that you can always then go and look at. And it's about getting that that win, that positive momentum regardless of how small it is, and then parlaying that into whatever the next idea, the next strategy, the next, the next place you're gonna go.

Dave: 22:55

Yeah. There there is one thing we should mention here. You can take this overboard. I see some traders that will, you know, whittle their trade set down, trying to get to, you know, something that's, you know, always profitable or above some threshold they have in their head that so they end up with a really small number of trades. Too too few too few trades to be able to trade profitably in in chasing that win rate, chasing that win percentage that they think you know, and the need to be right.

Dave: 23:39

They're they're trying to be right more than make money. And that's a that's a trap you can fall into, and you need to be careful to avoid that.

Michael: 23:48

Well, and I think there's some good, because I've run across some traders with the same problem. I think there's some very simple exercises you can do in Excel, that I had one guy run through to help with that where I said, okay. Let's build a 70% win rate strategy that has a 100 trades and, you know, pick a win rate. Right? 1.5 risk reward, and you just chart that out.

Michael: 24:11

I said, okay. Now let's pick a 51% strategy, that has the same risk reward but has 10,000 trades and chart that out. And you just see the the lines just go go crazy. So when we're talking about exploiting small edges over and over again, that that's exactly what we mean because we understand that, you know, I would rather take a very active 55, 60% win rate as opposed to take a very, very slow 90% win rate that only fires once a month. It's it's again, I'm just if you look at the numbers, even over not even a super long run, even over a short run, I think you'd be pretty shocked how compounding, a small edge is way better than doing nothing with a large edge.

Dave: 24:58

Yeah. I agree. And it's it's a balance because you you it's it's much harder to add trades to a strategy to improve it than to remove trades from a strategy to improve it. And so the more you whittle it down, the more difficult it's gonna be to modify that strategy. So as I go through this process in my own models, I'm always trying to remove the least amount of trades as possible to improve the system because I know that it's it's more difficult.

Dave: 25:34

Like, I I I see the path just gets narrower and narrower and narrower, and it becomes more difficult over time to to add more trace to the system, you know, go in reverse. It can be done, but it's just harder.

Michael: 25:50

I'm gonna go I'm gonna go real, real nerdy right now. Are you ready? Super, super nerdy. Have you ever heard ever heard of games called StarCraft? You ever

Dave: 26:00

we ever had a

Michael: 26:01

game in my life? So for the users who aren't nerdy, this is I always describe it as chess in real time where you have to control every piece in real time. And the other side is you can't see their board. They're actively trying to hide what's on their board. So it's very, very I used to play a lot.

Michael: 26:21

I used to play competitively a little bit like beer leagues and and that kind of stuff. And the idea is, right, you're building up an army, you're sending your army out. So I remember I was so into it that I actually would follow some YouTubers who would guide on, you know, proper builds and and pass and stuff. And one quote that always sticks with me is he said, your your build path is complete, not when you can add no more, but when you can take away no more. So the idea being that, you know, people try more and more just to say, hey, I want to do as much as possible and get as crazy as possible.

Michael: 26:56

But what ended up making me way better at this game is looking at it completely opposite. And I I I've always taken that through to trading as well, where we can use the indicator example. You'll always see that trader who's got a 1,000 indicators on their screen. You say, okay. How many of these can you take away and still see what you wanna see?

Michael: 27:14

And it's the same thing that you're you're saying with trade or with your your systems that if you take too much away, then you have no edge. If you add too much in, then you have no edge. So it's finding that middle ground of, of what can I cut and continue to cut before things get way too bad, that I'm really not having any kind of flexibility? I don't have, I don't have the indicators. I don't have the thing that I need to see in order to place the trade.

Michael: 27:41

So it is a balance and it's certainly very, very hard. But again, with the technologies that we have with back testing and everything that again, me and Dave didn't have at the beginning, I think it's way easier. You can just go through and and look at certain things like just using that RSI example again. It'd be nothing for that user if he's recorded those values or can get those values, to be able to go through and say, alright, well, you know, what happens if I do this trade? Whereas in the past, there would, a, probably be no way to get that data.

Michael: 28:11

And, even if you had it, you're writing out with a pen and piece of paper where the user now could use whatever journaling software they have or even so much as an Excel spreadsheet and just filter out this value. So, yeah, try to find the balance. And then the other part of it, and I I don't know if Dave is gonna agree with this, but I think is very important is, to focus a little bit more on the psychology of it as well. Right? There's one thing to say, you know, the optimal trades to take a day is 10.

Michael: 28:41

If that's too mentally tasking for you, I think you have to go suboptimal at that point if you can't automate. I I've dealt with systems before that should be very, very active, but I had to do too much interaction with it, and I found it, draining to the point that there was too much human error that took place. So the actual answer was to kind of go back in time and say I'm okay with this suboptimal equity curve if it means I can execute on that equity curve better than this completely optimal equity curve

Dave: 29:13

Yeah. I mean, you bring up a good point. There's no right answer here. Everybody has to decide for themselves what's the right number, you know, for their circumstances, how they feel their things are going, how how much buying power they have, how many strategies they trade. So, yeah, it's it's not something that you can Google and find the right answer.

Dave: 29:33

Right? It's dependent on your risk tolerance and everything about your situation.

Michael: 29:38

Absolutely. Alright. Did you have any other critiques for this this question?

Dave: 29:43

I think, I think that's probably it for this week. I, do have it's got me thinking about a bunch of different topics for new episodes. So Sweet. I think we could probably continue this, in a variety of different ways. But, yeah, I I'm looking forward to hearing how it turns out for Raj.

Dave: 30:04

We'll be sure to report back here on the pod.

Michael: 30:06

That was gonna be my next thing. I I'd love to hear an update in in a number of weeks once all the data's run and and see how that's going. And I'm glad you're coming up with new ideas. And and like I mentioned, I just tagged you in someone, I think, who had a really great idea for, a podcast on Twitter there. So I'm always super excited recording these.

Michael: 30:26

I hope you guys are equally as excited listening to them, and I think that was a fantastic one. And I'll talk to you guys next week.

Dave: 30:33

See you next week.