I believe we established that repeatedly trading a strategy with an edge is one feasible solution. But it does not necessarily maximize our PnL or minimize our MDD.
Any trader knows this from experience.
“This strategy works well in a bull market, but it doesn’t work in a sideways market.”
“It works well on Nasdaq, but not so well on Bitcoin.”
You hear and say things like this all the time.
In reality, few strategies have a universal edge. Most strategies work well in certain market environments and not in others.
So then, what exactly do we mean by a “strategy with an edge” from the previous discussion?
For now, I would define it like this:
A strategy that, despite all this, produces a profit in the long run when repeated.
But does such a thing really exist?
It would be a problem if we simply answered, “No.”
Then what, exactly, has all this blog stuff about probabilistic thinking been for?
Let me make one excuse, though.
For any problem, you cannot start by throwing in every complexity of the real world at once. You have to start with the simplest possible situation, then add realistic conditions one by one and make the solution more practical.
That is what we are going to do now.
And in that sense, we need to take a slight detour today (again).
To develop the simple strategy into something more practical, I first need to talk about the trading triangle I propose.
The trading triangle has three vertices:
Strategy, market perspective, and (trading) psychology.
And the strategy itself has another triangle:
Entry, exit, and risk management.
You are probably already familiar with the concept of a trading strategy. We will have plenty to say about it later.
For now, let’s talk about trading itself.
The First Vertex: Strategy
A strategy is the part where the trader actually takes action.
You enter, you exit, you adjust your position size, you set your stop, and you manage your risk.
Most traders spend an enormous amount of time trying to sharpen this vertex, especially the entry.
I think that is a perfectly reasonable thing to do.
As long as you do it properly.
The Second Vertex: Market Perspective
In a broad sense, market perspective is the way you look at and interpret the current market.
But let’s define it a little more narrowly here.
Choosing, among the market models you have, the one that best describes the current market.
The simplest examples would be:
“I’m bullish today.”
“I’m bearish today.”
“Oh, it’s a sideways market.”
This is probably what most people intuitively understand as market perspective.
But there are many other ways to model a market.
In quantitative trading, for example, you might define today’s market as Q43 and tomorrow’s as P45L.
Of course, Q43 and P45L are completely made-up garbage values I just pulled out of nowhere.
The names are not the point.
A market perspective does not have to be expressed in language that a human can understand.
So how should the modeling actually be done?
A market model has to be directly connected to a trading strategy.
A model is a simplification of the market.
So each state of the model comes with a performance profile for your strategy (or strategies).
Whether a model is any good comes down to one question:
How closely does the performance this model draws for your strategies match their performance in the real market?
If you leave that question out, then market classification is nothing more than classification for the sake of classification.
The Third Vertex: Psychology
The final vertex is the least mathematical and the hardest to approach rationally.
And it is probably the one closest to the ultimate subject of this blog.
Trading psychology, or simply psychology.
You could approach it using methods from the social sciences, but it is beyond my capacity to model it mathematically.
So for now, let me try to formulate it as best I can in my own language.
Psychology is having metacognition of how your judgment changes according to your trading results, and minimizing the inconsistency in your trading caused by those changes.
I originally wrote that it was about maximizing consistency in trading, but I changed it to this.
I think this is more accurate.
Ultimately, the point is not to eliminate emotions.
It is not about becoming someone who feels nothing after a loss.
Nor is it about becoming someone who never gets excited after making money.
It is about recognizing how your results change your next judgment, and minimizing the damage to your trading caused by that change.
I think this is a fairly practical way to define trading psychology.
These three things do not exist independently of one another.
They form a single body.
That is why it is a triangle.
If the strategy has no edge, there is no basis for the market perspective or the psychology in the first place.
If the market perspective is wrong, then by definition the strategy you have chosen is not working properly in the current market, producing essentially the same effect as having a broken strategy.
And what happens when psychology breaks down?
Then even a good strategy and a good market model are useless.
Without consistency, neither the model nor the strategy is of much use.
Therefore, when one collapses, the whole thing collapses.
In the next post, let’s focus a little more on market perspective.
I’ll talk about how we can improve the simple strategy we discussed in the previous post, why the strategies I used as examples last time (MDD 70%, three years of nothing and then all the profit in two days) failed to account for market perspective, and what “flexible adaptation,” as people like to call it, should actually mean.
This time, no more detours.
This article is educational content about trading and does not constitute investment advice or a recommendation to trade any specific instrument or strategy.