Lance
Ladia

The European Securities and Markets Authority (ESMA) requires that CFD brokers based in Europe must post the percentage of clients that trade with them and lose money. Between 74 to 89% of all traders with European brokers lose money.

Brokers are not interested in seeing their clients fail, rather the opposite. The profitable client is the client that trades more, and is eventually the client that will pay more commissions to the broker. One can argue that the infrastructure to trade has never been better: many brokers are offering extremely tight spreads, with low margins required, and the accessibility for knowledge, thanks to the internet and social media, has never been more free.

Why then, after improved infrastructure, is the failure rate so drastically high? Contrary to popular belief, institutions do not see to it that the retail trader fails. What I propose in this article is that the individual retail trader, despite meaning well, is actually beating themselves out of the market. And unfortunately, the current trading education space does little to mitigate the beatings. It has put the cart before the horse, and at times, monetized a cart with wheels that do not work.

The Brain in Hell: Trading is Cognitively Extreme and Unique

Do you remember your first trade? I do: it was on a small cap stock named GRRR. I was on the lucky end of a limit up market where I made my first $100 trading stocks. The euphoria from that trade was unimaginable. I imagine, if you won your first trade as well, that there is an equally strong euphoric experience from your end. If you didn't win your first trade, I imagine that you might not be here at all, and you will have said to hell with the market and gone about your day.

I remember there was a day I sat in a 9AM college class and had been staring at the market, waiting for it to open. I found a biotech company with the ticker RNAZ and once again found myself on the lucky end of a limit up market where I made my first $1,000 trading stocks. I immediately walked out of the class. I vividly remember the walk back to my dorm room, and I felt as if at any moment, a group of personal servants would pop out from the bushes and start rolling red carpet where my feet would land on my triumphant walk back to a twin bed where I slept in for the day after leaving class.

Why do I tell you this? I want to demonstrate how extreme the environment of trading is. I have experienced complete euphoria from trading, where at any moment, it feels as if the entire world were plotting in your favor, and conversely, experienced complete dysphoria, where it feels like not a single thing in the world can go your way.

The emotional reactions produced from trading are extreme because the cognitive environment of trading the financial markets with leverage is extreme. And not just extreme, but uniquely extreme and quite hostile to normal, human evolutionary behavior. I'd dare to venture and say that a normal human being, with normal thought patterns and behaviors, might fail to successfully trade the financial markets. Not that they are unintelligent, or lazy, but rather the human brain was specifically designed, by evolution, to abhor the conditions the financial markets present.

Knightian uncertainty is not the same as risk. Risk is able to be quantified: I risk, and I will lose at most, 2% from this trade. Knightian uncertainty is genuinely unknowable. No model can account for it, and the destruction that it runs on the brain is largely responsible for the extremes of trading. Out in the wilderness, there was no room for probabilities. There was only life and death. If you hear a rustle in the bush, you will likely survive more if you assume there is a predator there rather than if it was just the wind. Your brain is inherently not designed for uncertainty, as hundreds of thousands of years of evolution have equated uncertainty to a lesser chance of survival.

"Nobody, and I don't care if you're Warren Buffett or Jimmy Buffett, nobody knows if a stock is gonna go up, down, sideways, or in fucking circles. Least of all stock brokers." — Matthew McConaughey, The Wolf of Wall Street

Every trade you place is under an element of uncertainty. You can compute all the statistics you want, but you will never definitively know if a trade will win or lose. That is simply a fact that the human brain abhors. The brain will equate the discomfort of a trade to a threat to your survival. When your mind is uncomfortable and angry, what does that manifest into? Self-destructive behavior:

These are all physical manifestations of a mind that is in deep discomfort. All people are going to be unprepared for this because there is no prior experience that can truly emulate how this feels in real time, with money on the line.

That is another thing that makes this pervasive uncertainty even more destructive: leverage. From my trading today, a 0.35% move in the underlying NASDAQ represented a gain of 2.5% on my account. The same move downward would have represented an equal 2.5% loss. When someone is able to take $10,000 and control, in theory, millions of dollars worth of notional exposure, gains and losses accumulate rapidly. When losses accumulate, the brain must ease the pain of financial loss, which as empirically documented by Kahneman and Tversky, is twice as painful as an equivalent gain.

The operative idea between uncertainty and leverage is understanding that your brain does not process information. It does not process the numbers. It does not process the market you see in front of your eyes. It processes the emotional magnitude of whatever narrative you have sold yourself, which is likely a narrative of certainty, simply because that is the natural human tendency.

Between the emotional heaven and hell, it is virtually guaranteed that any trader's brain will start reinforcing feedback loops for particular behaviors. The probability of heads or tails on a coin flip is 50/50. That does not mean that each flip will alternate perfectly. You might get streaks of five heads. Statistically speaking, if you flip the coin long enough, you might see outlier streaks of ten or eleven heads. The distribution of these streaks is random, meaning that if you start flipping the coin right now, you could easily encounter that outlier streak. As the number of coin flips reaches infinity, the distribution will even out to 50/50.

A trader who has a strategy with zero edge, a 50% win rate where it is mathematically impossible to make money in the long run, might encounter a streak of six wins. This trader is feeling fantastic. No one can tell them no. The feedback is immediate: the money is in their account and they are withdrawing it as I write this, about to buy themselves some new clothes. The feedback is also, unfortunately, delayed. Their brain has now been conditioned to run the strategy because of the emotional feedback of this lucky fluke, and the delayed feedback manifests itself as ruin over the long run. They will fail to produce a profit over the course of 200 or 300 trades because their brain has conditioned itself to associate this strategy with profits, despite the fact that the math shows otherwise.

Slot machines exploit this same feedback loop psychology: bright lights and loud sounds reinforce the behavior of hitting spin, despite the fact that someone may conceptually understand that the house always wins. The failure rate is not an issue of knowledge, but rather traders being dropped into a cognitive environment that they could not have possibly known existed.

I Blame Stochastics: What Education Is Selling

Virtually all available trading education is filled with how-to's. How do I use the MACD and RSI? How do I trade a hammer pattern? How do I mark support and resistance? It is, at best, pattern recognition with a specific narrative attached to it. The TA provided by current trading education is not evidence-based and is cherry-picked to produce a marketable narrative.

A broker explaining the MACD will equate the 9MA crossing above the 21MA as a bullish signal and will cherry-pick examples while leaving out every example on the chart where the crossover does not work. The RSI is notorious for equating trending conditions as consistently overbought or oversold, with the narrative that the dominant move should be faded, despite the fact that a market in extreme trending conditions will likely persist with the same trend. A hammer candlestick pattern looks like a good tool to time every top and bottom, until you go back to charts and realize it occurs more frequently than you imagine and is not predictive of price at all.

There is a characteristic of the human brain called apophenia: the tendency to find patterns where no patterns exist. Again, a product of evolution. The education market has done a great disservice to traders because it reinforces aggressive pattern-finding with virtually no statistical rigor attached, but rather an emotional and certainty-filled narrative that does not hold up in live markets. Your brain and my brain will do their best to form some type of story around whatever chart they are looking at. Do not listen to it.

Well-meaning brokers with a genuine interest in client success still peddle these flimsy how-to's because the education itself is structurally flawed. They are not being purposefully dishonest. The issue is that many of the patterns and technical setups that are sold online and in books lack statistical validation that would make them distinguishable from randomness on any finite sample. What would the alternative look like? It starts with a simple question: how do I know whether or not this pattern is a real pattern against noise? Not how do I identify this pattern, but how do I test if this pattern has any predictive value?

The Role of Quantitative Analysis and Evidence-Based Technical Analysis

Before I write this section, I must preface that there is no feasible way that anyone can rid themselves of the uncertainty of the markets. It is its premier feature. Quantitative analysis only serves as a way to make the gap between knowing and not knowing a little more narrow. It is not a cut that is sutured fully.

The goal with any form of quantitative analysis or evidence-based technical analysis is answering one question: does this approach have a positive expected value over a large number of repetitions? Forget this trade. Forget the next trade. The mind should shift to a longer horizon. Day by day as we bob on with our lives, it is hard to see that the current is actually inching us ever so slightly closer to one direction. When you lose today, your brain will immediately and erroneously conclude that you have regressed. When you win today, the brain will think of how far it has gotten. The short-term horizon is dominated by noise and endless bobbing. Quantitative analysis shifts things toward the long term.

In all of my strategies, I employ a statistical method called binomial significance testing. It is not exotic mathematics and a high school math student can do it. It simply answers one question: given the sample of trades I have and the observed win rate, what is the probability that this result happens by pure chance?

Take a sample of 700 trades with a 54% win rate: 378 wins and 322 losses. The question is how often a breakeven strategy at 50% produces a result this extreme by pure randomness. The answer comes from how far 378 sits from the expected 350 wins of a coin-flip strategy, measured in units of standard deviation. In this case, 378 wins sits 2.12 standard deviations above baseline. That distance corresponds to a probability of 1.7%. If the strategy had no real edge, this result would occur by luck once in every sixty times. This strategy is worth committing capital to.

This one formula is the entry point for whether or not a particular pattern or strategy should have a single dollar committed to it. If one cannot statistically prove that a pattern can be exploited with results better than chance, it should have no money dedicated to it. Such testing never makes it to the education space, simply because it is easier to sell a pattern and a narrative rather than formulas that are imperative and foundational to profitable trading.

There is an erroneous belief floating around the trading space that psychology, discipline, and fortitude are what is needed for profitable trading. I agree to an extent. But no one leaves out the fact that even if your mindset is fortified with obsidian, it would not matter if you were trading a strategy with zero detectable edge.

Quantitative analysis shifts the questions and narratives. If I can statistically prove that a strategy is unlikely to be profitable by pure randomness alone, how will I feel when I come across a losing streak? Sure, I will be in pain when I lose five or six trades in a row, but I will be much more confident going into the next trading day because I have a degree of certainty in my strategy. I am not operating on blind faith. I do not have my hands bound to useless prayer that I will hopefully make money. Rather, I have put in the work to validate that it is likely I will make money over the longer term, and I should not worry about what this day or this week has brought me.

I must reiterate: quantitative analysis does not make the psychological harshness of trading disappear. It does however reframe the pain narrative. When the pain narrative changes from "this strategy does not work" to "this is just a losing streak in an otherwise profitable strategy," you are far less likely to deviate and engage in self-destructive behaviors.

Knowing and Doing

Richard Dennis allegedly turned $400 into $200 million. He turned novice traders into millionaire traders with his Turtle trading system. He reportedly said that he could post his exact strategy on the front page of the New York Times and still people would fail to make money. Dennis did not have a deep cynicism for human intelligence or discipline, but he understood that a profitable strategy means virtually nothing without the correct behavioral techniques. Are you able to take a loss and not override the framework? Are you able to tolerate periods of drawdown without abandoning the approach? Are you able to maintain an emotional equilibrium, win or lose?

Dennis understood that even a statistically validated strategy is still prone to the human tendency to override it in the moment. If a perfectly validated strategy has produced five losses in a row, the brain does not register a binomial significance test. It registers, and quite strongly, the pain of five losses in a row. Cognitively, the tendency to want to deviate from a perfectly sound strategy will always be present.

In my own experience trading an account at $3M for an office, I saw a drawdown across several statistically validated strategies. In the span of two trading days, I had gone one win out of twelve trades. I was ripping my hair out and began feeling as if the size I was trading was somehow large enough to where someone, somewhere was targeting and fading my moves. There was, of course, nothing wrong with the strategy, and I was not trading a meaningful enough size for any of my positions to be targeted. Even with experience and intellectual understanding that my strategies were statistically sound, the narrative feelings of explaining why something has lost will always persist.

These behavioral techniques, being able to take a loss, overriding your impulses, acting equanimously in the face of immense uncertainty and pain, are not things that are learned through a trading course or a broker. These are things that are learned through exposure therapy coupled with deep introspection. The act of thinking does not sell well, which is why there is virtually no trading book that will tell you that introspection is a necessary skill.

You can still fail with a validated strategy. Knowing is not doing. Doing is far harder than knowing. Having a statistically validated framework can remove some of the ambiguity on how to operate a profitable system. But it does not remove the requirement for behavioral discipline. It does not teach you how to be equanimous when faced with a losing streak. It cannot teach you to sit with an inhuman amount of pain. No book, teacher, course, or article can. Only you can.

Market information is neutral. Candlesticks are visual representations of price on a time axis. There is no narrative attached to a candlestick. The narrative is made by the human brain. When a narrative fails to play out as the brain has predicted, the brain will experience the pain of financial loss as well as intellectual loss. You were wrong, and no one naturally likes being wrong. The operative idea to neutralize the pain of being wrong is understanding that you do not need to be right or wrong on this trade. You need to be right in the long run. On each individual trade, the result is largely unimportant.

Sit down with yourself and think about your character traits. How do you handle being wrong? How do you handle being confused? How do you handle sitting on your hands and doing nothing?

I was, for the longest time, a person that was unable to look at their mistakes. After a big losing day, I could not open the chart and see where my trades were placed. It absolutely disgusted me. This is not a trait that serves anyone well. You must see your mistakes and learn from them. For a long time, I was a person that could not sit on their hands, and I would impulsively take trades on a one-minute or two-minute chart, trades that were not according to plan.

Naturally, the feeling of disgust will follow when you look at all your mistakes. This is the most powerful feeling you can experience, as disgust is one of the strongest catalysts for transformation. For the longest time, I was a person disgusted by my own body. My ribcage was visible and I was so skinny that you could see the left side of my chest beat in tandem with my heart. I discovered the gym when I was around 16. I started taking care of my diet and started to take pride in training with intensity because I was so disgusted with myself. Fast forward six years later, and I have built a body which I am satisfied with. My nutrition and training are intuition now. I trained like I was possessed and force-fed myself meals. I recall one instance where I had a 1,500 calorie dinner, then woke up several hours later for breakfast. I was still full from the dinner which had not fully digested and threw up my breakfast, which I remade without hesitation. Achieving these behavioral modifications and tolerating the discomfort of training intensely and eating beyond what my body wants were manifestations of disgust that I had over what I used to look like.

I think about it this way: I am not as enamored by the beauty of a bouquet of roses, as I am enamored by avoiding getting pricked by its thorns. Imagining my dreams and imagining what life would be like with them is cool. Imagining what would happen if I did not change and I failed is terrifying. So terrifying that I would do anything to keep it from happening. If this meant that I had to sit on my hands and tolerate the boredom of staring at a 15-minute chart, then so be it.

There is a myth of fearlessness in trading. I do not believe that as human beings we can ever truly rid ourselves of emotion. All we can do is build up the courage through repeated exposure to act against our own fears. The pain will always be present, regardless of how well-done a strategy's framework is. The key is acting equanimously. That, I believe, is the great secret to trading. It is not so much ridding ourselves of our human emotions, but rather acting in a way where they are not distinguishable from our actions. Much of human nature, our ingrained thoughts and behavior, is counter-productive in this environment. Overcoming this through self-control is the real challenge. It has and will prove to be a non-linear process.

Between Heaven and Hell

That is the great secret in trading: no matter how much statistical work you do, the pain and fear will never truly dissipate. It puts the trader on a tightrope between heaven and hell. On one side, there is the reality that happens where you give into your human nature and start lashing out on the markets, self-destructively. On the other side is an imaginative and idealistic world in which human emotions are able to be separated from a human brain.

Quantitative analysis cannot fully remove the balancing act, though it can dissipate some of the ambiguity. The rest of the balancing is up to the trader's will.

Build a theoretical framework, run statistical tests, and most importantly, learn to sit with an enormous amount of discomfort. Without doing so, no amount of math can save you.