“The only real mistake is the one from which we learn nothing.”

- Henry Ford

I recently wrote about how people can be fooled by selling strangles (equal amounts of out-of-the-money puts and calls). The fact that it is possible to make money trading strangles even if your forecast is wrong could be seen as a good thing. It emphatically is not. It leads people who should not be trading at all to think they have an edge.

Effective learning from experience requires two things: practice and feedback. In trading, we can’t do a great deal about the frequency of trading (practice), but we can make sure the feedback we get from our trades is relevant and valuable.

If you trade straddles (equal amounts of at-the-money puts and calls), the results of your trades will be far more correlated with the correctness of your forecast.

This feedback will allow you to better evaluate your trading because your results will more closely track your process.

Another feedback problem that we find in trading is that it can be tempting to disregard the information that says you aren’t very good, by just blaming bad luck (although people almost never attribute their success to good luck). The result of almost any single trade can be attributed to luck. The variance around our forecast will almost always be greater than our actual edge. The only way to separate luck from ability is to keep very good records.

A related issue is that of sample size. We need a lot of trades to come to any accurate assessment of our actual skill level. This is true whenever luck is involved (blackjack, poker, sports betting for example), but trading is more extreme because most trades are far from independent. Selling weekly straddles for a year isn’t 50 different trades. Because market conditions tend to persist for a while, this is much closer to doing the same trade 50 times. It is quite possible that if an option trader only analyzed trade results, he would come to the end of his career without a very good idea of his true ability. For this reason, option trading needs to be based on a solid theoretical method as well. This lets us somewhat bootstrap our knowledge and be more confident than we could be just by measuring results.

But this means you actually have to study, so you know what these theories are. This isn’t generally about math. Most successful option trading ideas come back to behavioral psychology, particularly the reasons that people prefer small certain wins and gamble with losses. There is a lot of information about this. Much of the best is free. But if you aren’t looking for it and evaluating your trading as you learn, then you should probably stop trading. It is almost certain that any success you have had is due to luck. And don’t cheat. If your grasp of psychology is “fear and greed”, then you are faking it.

You will only fool someone stupid. Don’t let that be you.

Euan SinclairComment