Negatively Skewed Trading Strategies

 

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Some years ago I traded with Echotrade. I remember what one of its principals said about new pair traders that started trading with them: oh no, he’ll make a lot of steady money, but ultimately he’ll lose it all, and perhaps even more. His experience was based on the objective numbers from the firm: pair traders did not last long. The reason is that their strategies are usually negatively skewed (click here for a negatively skewed distribution). Why is that? The majority of them play the Martingale strategy*: they add to losers. Problem is, you get away with this most of the time. However, once in a while you get stuck into a pair that does not mean reverse. The loss simply gets bigger and bigger. When I started trading in 2001, I remember one trader doing merger arbitrage. The spread grew bigger and bigger but he kept on adding new positions to it. Later the deal was called off. In the end he lost 5 years of profit and gave up trading.

Skewness has a probality distribution that is not normally distributed.  I think a lot of traders fall prone to this. I certainly did when I started, but luckily I learned fast and understood this. Most people don’t think about that their strategies can be negatively skewed. I strongly recommend reading this article.

Some of my strategies are automated. And I know for sure: some time a fat finger or a program error will come and hit me like a boomerang. However, unlike most other traders I’m aware of the skewness and have it in the back of my head all the time. I make sure that my losses are limited in case it happens. Because I know it will happen.

The worst that can happen to a new trader, is to make much money from the start. The chances are that he’s just being lucky. It will feed his ego and increase his risk. He’ll not learn. I have yet to see a trader that does not experience significant losses from time to time. The more you learn, the better you can handle those losses.

*If it’s part of the strategy I see nothing wrong Martingaling. However, that is only to add small units to get a full unit. For example, if you want to build a position of 100 000 USD as a part of a larger portfolio, you can add three units of 33 333 each. There is no way you can pick tops and bottoms, therefore I see nothing wrong with adding to losers if done this way.