What Is A Good Process?
What is a good trading process? Should you stick to a process if you’re currently losing money? If you’re not getting the results you want, when do you fix yourself and when do you fix the process? Or better yet, when do you call it quits on the process you’re currently using if you’re not seeing results? How long do you need to see results?
I talk a lot about “the process” and its relationship to your psychology. I think now is a good time to go into more depth about what this looks like.
The Basics of a Good Process
On the one hand, a good process is simple. It is one where you are consistently profitable. It shouldn’t be more complicated than that. However, how can you tell a process is consistently profitable before you start using it?
There are a lot of charlatan trading programs out there. They often talk about making exorbitant returns like 1% a day compounded for a year on a consistent basis. They also talk about a good lifestyle where you can do this for 10 minutes a day and make obscene amounts of money. It’s easy money!!!
People fall for this type of offer every day. And, sadly, they lose real money in the process.
Let’s say the claim is not so exaggerated. What if it’s just teaching you technical analysis? Or maybe teaching you how to trade with options? Or maybe it’s showing you how to trade crypto? How can you tell whatever you’re learning is actually a “good process” for the purposes of becoming a consistently profitable trader?
There are multiple layers to assess. I’ll label them as follows:
- (1)
The Math Layer - (2)
The Growth vs. Risk Layer - (3)
The Historical Layer - (4)
The Execution Layer
The Math Layer
The first level of determining whether a process is good prior to executing the process is looking at the math. Let me show you two scenarios:
- When you flip a coin, you make $1.50 if it is heads and you lose $1 if it is tails
- When you flip a coin, you make $1 and you lose $1.50 if it is tails
Which process is consistently profitable over a long period of time? It should be obvious that it is the first. Math = ($1.50 profit x 50%) + ($1.00 Loss x 50%) = $0.25 average win per flip.
You’d think that this part is easy. The problem is that many processes use complex jargon and concepts to make it hard to figure out what the probabilities are and what the payoffs are.
Let’s use an outrageous crypto example. If someone tells you that you can make 100%, or 10x or 100x your money, that’s great! But what’s the probability that it will happen? 100%? 50%? 1%? They often don’t tell you that. It clearly can’t be 100% because if it was a sure thing, the profit would have been made already. Let’s say, for argument’s sake, it’s 50/50 that you can 100x. What happens when you lose? Well you’ll likely go to 0. However, this is great! If you 100x 50% of the time, you’re sure to make at least 50x over time.
However, if you play this game 10x and put all your money in every time, what is the probability you’ll wipe out? The probability is 99.9%. Why?
If you play this game 10x and put all your money in every single time, then you need to win EVERY TIME to ensure you don’t lose all your money. The minute you are on the wrong side of the 50/50, you lose 100%.
So what’s the probability of winning 10x in a row? It’s 1/2 times 1/2 10 times. Which is another way of saying one half to the power 10. (0.5)^ 10. This = 0.000977 or 0.0977%
That’s the probability of winning 10 times. So the probability of losing once is one minus that number which equals to 0.999023 or 99.9%
Therefore, this strategy, mathematically, is not consistently profitable. Can it become consistently profitable? Sure. If you choose to bet a smaller fraction of your entire trading account. It can be wildly profitable. But not at 100% investment rate.
Check out Kelly Criterion to learn more.
Another, real life, example I came across had to do with selling options. I was going through a course on teaching me how to sell options every month to make consistent returns. They advised selling options with high Volatility with the expectation of Volatility declining. I went through the course and it made a lot of sense.
However, there was one problem.
According to the program, I calculated that the probability of profit was 23%. Great!. However, the $1 option spread I was selling would go for $0.15 in the market. If the market went my way, I would pocket $0.15. However, if it went against me, I would lose $0.85. When you do the math, there’s a $0.08 expected loss. Math = ($0.15 Profit x 77%) + ($0.85 Loss x 23%) = $0.08 Loss every trade.
They talked about this discrepancy and their explanation was that “historically speaking, realized volatility is not as high as implied volatility, so even if you’re getting less than what the expected rate of return calculates, you will still be profitable.” They also spoke about loss mitigation strategies that paid no attention to the fundamentals of the underlying security.
I’m sure some people are making money this way. However, for me, the math didn’t make sense. I learned a lot about options from the program. However, I could not implement the strategy because the math simply didn’t work.
The Growth vs Risk Layer
Once the math is all figured out (or maybe too vague for you to actually calculate), the next layer to identify a strong process is what I like to call “The Growth vs. Risk Layer”.
The overall economy grows at a certain percentage. Certain industries grow higher than this percentage and other industries grow at a lower percentage. Overall, on average, when you sum everything up, it will equal to the overall economy.
When you are small, you can put your money into high growth areas. However, high growth areas usually involve more risk. As you get bigger, you begin to run out of those high growth opportunities and have to settle for lower growth opportunities. It’s the way returns work.
When a trading program promises a specific amount of returns and they don’t talk to about the risk, they’re doing you a huge disservice. Why risk 100% just to make 50%? Those opportunities are plentiful! Heck, I’ll give you that opportunity right now if you want any day of the week. Just ask. I’m that nice of a guy!!!
The truth is that there is only so much growth that exists in the world. Whenever someone promises that you can make a lot of money, you have to ask yourself, “Where is the growth coming from?” And if the growth is so great and so good, it makes more sense to trade with the program than sell it to others. I sure don’t want to sell my process here!!!
Whenever I hear about day trading programs where people buy and sell within the day, I cringe. I sometimes hear people talk about making 1% a day consistently. The reason is because there often isn’t enough volatility within the day to truly make money on a consistently profitable basis. Most days are boring. There are big moves when there are major catalysts that change expectations such as earnings reports, economic numbers, policy changes, etc. Many of these can be predicted as they are scheduled but many are unpredictable as well.
To say that you can be consistent trading every day by buying one security and selling it within the day doesn’t make sense in the long run. Such a fund would consume the world within 9 years as it would grow to $156 Trillion, larger than the world’s GDP by a large margin.
As you can imagine…That makes no sense.
How much growth could you possibly be consuming and at what risk level?
The Historical Layer
History is a good guide on what has been done before and, therefore, what could be done in the future. Don’t get me wrong, it is possible for new things to happen in the future. However, if things have happened in the past, it means there is a process that exists and it works. This process is time tested by history.
Many trading processes that are sold do not stand the test of time. They’ve only been around for a few years (or even just months). There’s no major history. But sometimes you’ll get an advertisement about “Chat GPT guiding you trades!” (I just got one of those e-mails).
I guess there’s a reason why it’s new. However, it’s often a gimmick. How can I tell? I can’t. But it still deserves to go through the multiple layers outlined here. And it’s not winning any points for historical basis.
Most trading programs I’ve seen don’t boast historical use. The Institute for Trading and Portfolio Management (ITPM) is different.
I’ve used ITPM with much success to improve my trading from a typical retail trader losing money to doing what professional hedge fund managers do. I’m a proponent of their product. I will also admit that my website has affiliate links. I will be 100% transparent that they are not perfect. However, I believe they offer the best education for its class when it comes to learning about how to trade like a professional trader.
This is the best example I have of a trading course that satisfies the historical requirement for identifying a “good process”. Namely, that professional traders have used this process in the past and continue to use it to this day.
What is the process?
- You understand fundamental macroeconomic dynamics of the world
- You then drill down to sector dynamics, and then specific company dynamics.
- Afterwards, you make a trade where the reward to risk ratio is very high and worth your time.
The Execution Layer
The final layer in the process of identifying a good trading process is the execution layer. This is where you figured out that a process makes sense through the Math, Growth vs. Risk, and Historical layers. If it does, then the question is whether the process is being executed by individuals currently and whether it can be executed by you.
This is where psychology comes into play. If your mindset is not appropriate for trading, you will do poorly with any process. However, sometimes, a process can be good for some people and bad for others.
For example, in the book “The Biggest Loser Wins” by Tom Hougaard, he talks about adding to winners as part of his pivotal strategy and one of the major keys to overcoming the mental game of trading. However, in the book “Trading in the Zone” by Mark Douglas, he advocates for taking some profits along the way up as a way to create long-term positive benefits.
Who’s right? Well, they’re both presumably consistently profitable traders with good processes. However, there is something about Tom Hougaard’s psychological makeup where he feels MORE pain missing out on more gains than taking a loss. Therefore, his process is to add to winners, even though he may lose his gains. On the contrary, Mark Douglas might have a different mentality where taking profits along the way up benefits him.
Everyone has a different psychological makeup and, therefore, will need different tools for the same goals to complement that psychological makeup. These tools should help dampen the worst parts of ourselves while promoting the best parts of ourselves.
The execution layer takes time to develop, but if you know yourself well, you’ll learn whether a particular process may or may not be right for you.
Bringing it all together
How do you tell whether a process is good before you start using it? You’ll need to analyze it from 4 main perspectives:
-
Mathematically
Does it mathematically make sense? Do the math, calculate the returns. What happens when all goes well? What happens when nothing goes right? What numbers can you input, what numbers are you missing?
-
Growth vs. Risk
Where does this process fit in the overall Growth vs. Risk profile? If done infinitely, does it suggest it will take over the entire economy? Where does it fit in the overall economy?
-
Historically
Have people used this process in the past? Do they currently use it?
-
Execution
Even if the process is good for others, it might not be good for you specifically because of your psychological characteristics. That’s okay, but you need to know yourself really well to sort that out.
I hope you found this article helpful. Happy Trading!
Your trading psychology might be the deciding factor for your next BIG win or your next BIG loss.
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