Discretionary alpha is a term I’m rather enamored with right now. It is a derivative of “incremental alpha attributable to discretion,” which is described here by Henry Carstens, who attributes the phrase to Dr. Brett Steenbarger.
Due to discretionary alpha, short positions in my personal account are just a smidge in the green as of Friday’s close. The audited system account will not have this benefit as discretion is forbidden, and as a result, it will likely record a loss on its first trade. Ahhh…the beauty of incremental alpha attributable to discretion.
Truly, this week was difficult for me as I was focused on working through the painful feelings associated with a developing drawdown. I was reminded of Chart Addict’s post Trader’s Mindset and Common Psychological Issues as I knew that if this latest trade ever turned in my favor that the good feeling would not be stronger than the pain of having it go hard against me. As the trade is now in my favor, I polled the voices in my head, and they assure me the pain was worse than the relief. I think that pain will always be stronger than relief, and that the trade would have to go in my favor from the beginning and earn 2-3x the expected profit to feel joy equally as strong. Even then, it may not be as powerful of an emotional response as the pain of a deepening drawdown.
To understand that the pain of losing will always be stronger than the joy brought from winning is very very important. The realization of this forces into focus that the most important reason for trading is not to feel intense joy or pain but to make money. It is easy to get addicted to the rush of winning and losing, but since winning is never as powerful as losing, one is much more likely to intervene and over-ride during a losing trade. This intervention by the trader will likely occur at the worst possible time.
I don’t know what it was about this week that made it so hard to stay short. Maybe it was the cheerleading by CNBC, or the constant jawboning by Obama and the Feds. Everywhere I looked, listened, and read, it was as if the markets would never pull back, ever again. As crazy as everyone was, it was difficult not to jump on the bandwagon filled with crazies and ride off into the sunset.
But I resisted, stuck with my models, and will have a smaller loss to show for it. And that is what I’m focusing on…not the emotional highs and lows, but instead on the satisfaction of following the system, and by default, gaining a degree of control over emotional responses to trading. This is not a game, or gambling. It feels more like how I imagine a Restaurateur may feel after a slow week….
Right on, Wood. I went through the same emotions as I started getting short on 3/12, and added positions on 3/17 (the beer had nothing to do with it…), based soley on my mechanical system. I must admit, I ignored 2 signals over that period, the last one given on 3/18 which would have gotten me more short on 3/19 with a position taken at the open. Now I am kicking myself for pussing out. The psychological aspect is without a doubt the most difficult aspect of system trading. I am now still net negative on those positions, but barely. Had I taken the trades I ignored, I would be up. I’m still short. The system hasn’t taken me out yet.
Here’s what’s really interesting to me from a psychological standpoint. This isn’t the first time I’ve had a hard time pulling the trigger when my gut told me to override my signals. And it’s not the first time succumbing to the emotion would have either left me with a smaller loss or a gain. Now, after a while, you’d think that those experiences would count for something in your psyche. Like getting comfortable with riding a bike. The first several times you crash, you’re reluctant to continue. But after a string of “wins” (i.e. riding the bike without bashing your skull open on the curb), and seeing that over the long haul, it’s “safe” for you to ride the bike, you no longer have the fear. Even though the risk of falling off and suffering a subdural hematoma is still just as real as before. But I still never feel truly “comfortable” every time a signal is given, even though I’ve backtested and run through many iterations showing that the system is robust in the current environment. The human mind is a strange thing, indeud.
Hey Woods maybe run a test where ‘random chaotic actor X’ interacts with your system. If results make the grade maybe you can hedge and average and trade random stocks on top of your system, day trade futures based on livewithoscar’s big red down or green up arrow lol
Excellent reflective post, Woodshedder. Never heard of “discretionary alpha” (Incremental Alpha Attributable to Discretion) before. Good read.
Keith, pretty cool, yet simple concept, eh?
My personal account trade is not yet closed out, but I figure that IAAtD will be near 2-3%, over the system account.
Woodshedder,
I will echo the sentiments expressed by Keith Shepard. Your last two articles have been very helpful for a newbie system trader like myself. Unfortunately for me, I started trading my mean reversion system for real at the end of January ’09 and lo and behold I’ve experienced two back-to-back bad episodes of drawdown – the prolonged downturn in February and then the prolonged uptrend this month. Of course, I made the rookie mistake of over riding my system in February and sold my losing position at the worst possible time, when I couldn’t take the pain of the actual significant drawdown even though my back-testing had shown that it would and will occur…but its different when you have actual money on the line. Had I stuck to my systems, my losses would have been less than half the amount they were. Expensive tuition. 🙂 Long story short, having read CA’s and your posts, I’ve stuck to my system signals this time around. And you are right, the pain of drawdown is stronger than any joy of knowing that my system is doing what is meant to do. Keep up the good work and articles. They have been very helpful.
One way to help with the drawdown pain is to position size using a worst-case scenario intraday trade drawdown from backtesting results and size accordingly so that still lies within your pain-threshold in dollar terms.
Right on.
wood- as they would say in my church “that will Preach!!” thank you thank you thank
you — breakthrough blog for my learning
One thing that has helped me quiet the voices in my head telling me to override my systems is to think about System Performance instead of Trade Performance. Your system performance is made up of many, many trades. Unless your win % is 100%, you will get some losers. So, if you can step back and take the bigger view than it can help quiet those voices. Spend your time doing system analysis or new system research to keep your mind off of the current trade. The current trade is just one of hundreds or thousands you will take over your trading career.
Thanks for writing about this important topic for system traders.