Tuesday, July 22, 2008

The Costanza Problem

These are particularly difficult times to be trading. Within the last two months 2 of my long time trader buddies have managed to blow out their accounts and have decided to pursue other paths. The collateral damage to family relationships, general health and mental attitude is often substantial and underestimated in situations like this as "risk capital" devoted to trading may really have been earmarked for more important functions. I am deeply saddened by these recent events as the fallout is typically not resolved quickly or without considerable anguish.

In both cases the traders had more winning trades than losing trades. In both cases the problem derived from the fact that the losing trades were substantial and they failed to cut their losses or go market neutral when the opportunity arose. I find this weakness in my trading also and am constantly working to correct it. One way to deal with it is to auto trade, where stops and exits are applied automatically, thereby removing the component of subject emotion. This tactic has its pitfalls also as it involves a leap of faith that most traders are unwilling to make.

I was stunned to hear these reports as I respect both men immensely both as traders and really nice guys. One of the traders, "J", said that as he looked back over his trade journal he realized that his main problem was a failure to deal with "The Costanza Problem", an issue I described in an article that I wrote a few years back for a trading symposium.

As a cautionary note to other traders, portions of that article are repeated here:

The Jerry Seinfeld sitcom often featured George Costanza, a character who was a serial loser by his own admission. George was frequently unemployed for long periods of time and was forced by his poor financial situation to live with his parents whom he found every opportunity to denigrate and demean. Although George tried almost every job imaginable, he always found a way to get fired, often under embarrassing (and hilarious) circumstances. His personal relationships and his professional pursuits were a series of unending blunders. George’s inability to make either personal or professional commitments doomed him to a world of constant conflict between Relationship George and Independent George. As George was fond of saying, "A George divided against himself can not stand”.

George was a comic success because of his personality quirks, but a deeper analysis of his multiple character foibles provides an insightful look into the types of behavior and attitudes that can help traders succeed.

While George frequently acted like the poster boy for deviant behavior, he was merely displaying an over the top version of many of the negative traits that traders must avoid in order to become consistent winners. Failure to be honest with one’s self, lack of training, lack of a professional attitude, lack of self-discipline, lack of patience, lack of focus, poor capitalization, poor planning and/or the inability to formulate and follow a plan are all examples of self-destructive behavior that traders must overcome.

In a particularly watershed episode George experiences a glorious epiphany that everything he has ever done in his life has been wrong and that to rectify his failures and now become successful he must behave exactly opposite to the way he has behaved in the past. George undergoes this realization while in a cafe and immediately approaches to the back of a very attractive, apparently unattached blonde perched at the bar. Completely contrary to his usual attempts at gaming and self-deception he openly declares, “Hi, my name is George, I’m unemployed and I live with my parents”.

The anticipated result of this encounter is, of course, that the blonde will turn away from George in disgust and disdain. But with an inviting smile she turns to George and says, “Hi, I’m Victoria, it’s so nice to meet you.” It is in this moment of brilliant clarity that George ceases to be divided against himself and presumably later reaps the benefits of his new persona off camera with his new lady friend.

In like manner, a mantra for traders might be, “A trader divided against himself cannot survive”. How can a trader formulate and effectively utilize a unified mindset and attitude that will enable him to emulate George’s awakening and trade with calm, clarity and consistency? The ability to successfully answer this question is fundamental to a trader’s longevity and the shape of his equity curve.

The very nature of trading requires participation in a dynamic, probabilistic and opportunistic environment characterised by uncertainty and risk. At the same time trading is a zero sum game and utterly impersonal. Other traders have no regrets about taking your money and eating your liver for lunch, presumably with some fava beans and a nice Chianti.

There are always unknown forces and traders operating in the market with diverse goals and strategies that may not be logical or probabilistic according to your perspective. If you believe anything can happen in the markets then you will always be right.
In addition, Murphy’s Corollary usually prevails: “Anything” will most often happen when you least expect it or when it is most disadvantageous to your market position.

The real trick is to approach the markets with no agenda other than to let them unfold as they may. If you utilize a quantified trading edge then the laws of probability will prevail over a series of winning and losing trades. If you don’t expect the market to make you a winner every time you place a trade then you will have little fear of losing. Maintaining a clear and focused state of mind is your best tool to help recognise and take advantage of opportunities the market makes available to you.

Once the inherent uncertainty of the market is accepted as fact your success as a trader will increase dramatically. Consistently successful traders develop an almost detached state of mind that treats trading as a probability game because they know with a high degree of certainty what a trading edge looks like and how to determine if it is working, and they have a trading plan to mitigate risk and to define how to take profits and cut losses.

Consistently profitable trading results from acquiring and embracing the tools to master these technical, tactical and mental skills rather than focusing on making money.

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