Monday, August 23, 2010

The myth of methodology

Over the course of the next week or two, as “summer” winds down and I begin sowing hairy vetch and oats in my vegetable beds in anticipation of a more bountiful harvest next year, I’ll offer a mix of book reviews and some brief posts based on Scott Berkun’s The Myths of Innovation (rev. ed., O’Reilly, 2010). Today I’ll explore the applicability of the myth of methodology to trading.

A method is a systematic way of accomplishing something. Consider a well-practiced chemistry experiment. “[N]o matter how late a person was out on a given night, or how many bars he visited before sleeping in his car, if he faithfully followed the methodological formulas of chemistry, he could achieve the same results repeatedly without risk.”

The myth of methodology is “the belief that a playbook exists for innovation [which] removes risk from the process of finding new ideas.” (p. 37) Nonsense, Berkun writes. “There is no way to avoid all risks when doing new things. … Even the scientific method, the process behind the ubiquitous ‘rocket science,' doesn't promise success—consider the Apollo 13 mission or the Challenger space shuttle disaster. And methods created by gurus or famous executives fall well short of predictive.

“Faith in the myth of methodology … can inspire people to overcome their fears. But don’t confuse inspiration with execution—passion and confidence are fuel for work, but they don’t guarantee success." (p. 38)

Of course, the trader is not an innovator in the course of his daily business; he doesn’t try something new each time he puts on a trade—or at least one hopes he doesn’t. So the myth of methodology has to be rejiggered a bit to fit the trading environment. We might rewrite it somewhat along the following lines: A trading playbook exists (or a set of trading playbooks exist) that will consistently maximize profit and minimize risk.

The problem is that we know that the rules of science don’t apply to trading. We can’t faithfully follow a trading methodology and expect to achieve the same results repeatedly. We can’t even expect the same results X% of the time. The market is not a controlled environment like a laboratory. As a result, no matter how robust a methodology seems, no matter how intuitively obvious it may appear, we know that it will fail. We just don’t know whether it will fail an acceptable percentage of the time or whether it will blow up completely. And, yes, odds are that the trading methodology will blow up, though we don’t know when (it may work for weeks or years) or what will provide the catalyst.

Moreover, whether the trader follows a plan that provides room for discretion or trades mechanically, he isn’t like the debauched, robotic lab instructor. Unless he is trading on autopilot, it may make a great deal of difference to his potential success how late he was out or how many bars he visited the night before.

1 comment:

  1. Interesting treatment of "methdology." A robust methodology will work in any time frame traded and with anything that creates a non-swiss cheese (very thinly traded) chart. Are you confusing trade setups with methodology? Personally, I have found that pivot trading combined with an understanding of price action within cnadlesticks has lead to consistently profitable trading over a 9 year period. Whatever methodology is adopted, it must resonate with the individual. Totally rules based trading within a robust methodology should yield the consistent extraction of capital from markets. If it does not, then your methodology is faulty, needs adjustment or abandonment.