Thursday, December 10, 2009

Trading efficiency

Van K. Tharp is a prolific writer, trading coach, and workshop promoter. His latest book, Super Trader: Make Consistent Profits in Good and Bad Markets (McGraw-Hill, 2009), repeats themes familiar to anyone who has read his earlier works. But in passing he has a new target—economists who subscribe to the tenets of behavioral finance and who ask “If markets are not efficient because humans are inefficient, how can we use what we now know about human inefficiencies to predict what the markets will do?” This, he contends, is lunacy. (p. 215) Perhaps, but I would refer my readers back to my post on Richard Lehman’s Far from Random (12/4); I think there’s merit in including a behavioral component in modeling the markets.

Tharp says that he practices applied behavioral finance but claims to take a different approach. “If most human beings are inefficient in the way they process information,” he asks, “what would happen if you started to make them efficient?” Put simply, in his recasting of the notion of efficiency, what would happen if traders made fewer mistakes? Tharp defines a mistake as a trader not following his written trading rules. Common mistakes include doing anything because of an emotional reaction, risking too much money on any particular trade, and not having a predetermined exit when you enter the trade. (pp. 222-23) Personally, I agree that risking too much money on a trade is a mistake, but emotions can provide powerful clues and a predetermined exit can cut profits short. These criticisms, however, are peripheral to today’s post. What I want to take away from Tharp’s attempt to keep an arm’s length away from behavioral finance is the idea of trading efficiency.

What would happen if we used the common notion of economic efficiency and said that our goal is to use our resources in such a way as to maximize our profits? In one sense, of course, this is moronically obvious. But if we drill down just a bit, we can say that our goal is to reach a state where (to quote the Wikipedia article) “more output cannot be obtained without increasing the amount of inputs” and “production proceeds at the lowest possible per-unit cost.” (We need not address the zero-sum notion of the economic efficiency of markets that says “no one can be made better off without making someone else worse off.”) Of course, trading and investing are very different beasts from, say, the manufacture of cars, but I think that we might profit from trying to apply the notion of efficiency to our trading and investing plans. For example, we might try to figure out what combination of options and stocks most efficiently creates our desired risk profile. Or we might use Kaufman’s fractal efficiency to assess our performance. Keep thinking imaginatively; the folks making billions are.

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