What follows is PART TWO of a three part interview with Dr. Doug Hirschhorn, author of the book 8 Ways to Great, frequent CNBC contributor, and well known peak performance coach, whose clients include many top traders at hedge funds and banks around the world. The topics discussed will include the following:
The most important factor in a trader’s success.
Why top traders seek the benefits of coaching.
Are top traders born or made?
Trading is the hardest way to make great money.
Are female traders better than their male counterparts?
The role of fear and fear?
PART 2
Thinking in probabilities: Probability + Payout = EDGE
Risk vs. Reward.
The average winning percentage for top traders.
Process trading explained.
A great baseball analogy.
PART 3
Proper goal setting.
The C.H.A.M.P. Process.
Accountability.
8 Steps to successful journaling.
Treating the trading game as a business.
The best books to read.
Four differences between sports and trading.
The primary goal of 8 Ways to Great.
PART 2
CHT: Right! In your new book, 8 Ways to Great, you say that successful traders think in probabilities. What do you mean by this, and can you give us an example?
DH: Yes I will. Now this is one of those things that some people are actually hardwired to think this way, and other people are not, but either way, what I’ve discovered is that anyone can learn how to think in terms of probabilities. That’s a critical element to success and trading. So, here’s an example and David, I’ll use you as the person to help me out with this. If I told you that you had a 96% chance to win at a game, would you want to play that game?
CHT: Absolutely!
DH: Right. And most people out there will say absolutely, and, in fact, a lot of the traders that I work with will say, “96% chance to win, of course I want to play that game. And I then say, “Great, let’s play that game. Every time you win I’ll give you a penny, and every time you lose, you give me a thousand dollars.” Now the person thinks, “Well, you know, that doesn’t sound so good, don’t I want to play that game anymore.” And so I say, “Okay, lets flip it around. How about this, if you had a 3% chance to win at a game, would you want to play that game?” Let me ask you, David, “Would you want to play a game where you only had a 3% chance to win?”
CHT: No way.
DH: Okay. Most people would say that because 3% chance to win, doesn’t sound like it’s a good game to play, because you are going to lose a lot. But again, remember, it’s not only about the winning or losing percentages. The correct thought process has got to be, well, how often I win or how often I lose is only as relevant as how much I’m going to make when I win, and how much I’m going to lose when I lose. That concept right there, is the equation that people don’t take into account in trading, and that’s the part that differentiates mediocrity from greatness in trading. It’s the ability to actually look at a trade in terms of two functions: there’s the probability that a trade’s going to work out or not, and then there’s the payout that’s going to result. And that’s a very distinct data point to consider, because the combination of those two things, the probability and the payout, is what gives a trader their definable edge. By Edge, I mean it’s a trade they should be doing not because they want to do it, but because mathematically it’s the right trade to make. Now, some people that I’ve come across, and mostly they’re options traders, naturally think in terms of probabilities. (Because at the end of the day, a trade that has a 96% chance to work is just a deep-in-the-money option. And one that has a 3% chance to work is a deep-out-of-the-money option.) What I do find interesting, though, is that most people don’t pay attention to the element of payouts on trades because they got caught up in the win/lose part. The human driver behind this is, that people like to win and they don’t like to lose. Traders especially don’t like to be losers and get things wrong and as a result, they get distracted by if it has a high winning percent, it’s a good trade, a low winning percent, it’s a bad trade. When you break it down to what defines success, and when you look at the statistical performance of traders, the average winning percentage is between 45-55%. Let me say that again, it’s between 45-55%. People are shocked at that information. But that’s what the numbers say, that’s not my opinion, that’s what the data say. What differentiates profitability from not being profitable is not how many times they are right or wrong but it’s how much they make when they’re right versus how much they lose when they’re wrong. And I’ll tell you something even more compelling, is that a lot of my most successful clients, the guys that make tens to hundreds of millions of dollars a year, their winning percentages are actually less than 50%. That means they are wrong on their trading decisions more than half the time. And people say, well how is that possible? It’s possible because when they’re right, they’re holding those trades a lot longer and when they’re wrong, they are cutting those trades a lot quicker. So it’s not about being right or wrong, it’s about accepting the fact that you are going to be right or wrong half the time; but when you’re right you are holding on to the bigger position and when you’re wrong you’re cutting those positions very quickly.
The formula I give people to think about is a simple mathematical equation: probabilities times pay out gives you what’s called your edge. (Probability) x (Payout) = EDGE. As long as the math adds up in your favor, then you have edge in the trade, and you should do that trade.
CHT: So in other words, you could really have someone who has a winning percentage of, let’s say, 80-90%, and they can lose money, whereas you have another person who only has a winning percentage of, let’s say, 20%, 30%, and they could actually make money?
DH: Yes, and I’ve had those clients before. I had a client once who had a 75% winning percentage, it was remarkably high, and he wasn’t able to be profitable. When you broke down his trades, what happened was, he would take his small winners off the table and he would hold on to his losers a lot longer and add to them, and as a result he had a lot of winners but they were a lot of small winners, and he had fewer losers but they were very big losers. It’s like, you make $1 every single time you win, but you lose $20 every time you lose, and at the end of the day, you are going to end up in a losing situation even though you have a 75% winning percentage.
CHT: Yep, absolutely. In 8 Ways to Great, you talk about how important it is to focus on the process and not the outcome. What do you mean by this and how does it apply to trading?
DH: The process mentality means that you’re looking at the steps, the little pieces that go into place to get you to the bigger picture in mind. So I’ll go back to a sports example here, a baseball example, which will help people understand it more clearly. David, if we’re talking baseball and I told you I went 0-for-4, would you say that I had a good game or a bad game?
CHT: On the surface, a bad game.
DH: Right, and most people would say that. 0-for-4, that’s a .000 batting average so you must have had a bad game. Let’s look at this again using these two scenarios. Scenario one is I went 0-for-4 but my first at bat I hit a line drive to center field and the guy caught it. My second at bat, I hit a bomb to left center and the guy laid out and caught it. My third at bat, I hit a dart to third base and he threw me out from his knees. My fourth at bat, I hit a line drive back to the pitcher.
Scenario two is I went 0-for-4 and I struck out 4 times without swinging the bat. Now let me ask you the question again, in both scenarios I went 0-for-4, but now would you say I had a good game or a bad game? The difference now is you are thinking, “Well I guess it depends. In both situations, the outcome is my batting average is still .000; but there clearly is a difference between the my performance and confidence level in scenario one, where I am hitting the ball hard but getting out, versus scenario two, where I am not hitting the ball at all and am feeling low on confidence.” That’s what I mean by having the Process Mentality. For traders, the process mentality is focusing on making High-Quality Trades – meaning, trades that you have edge in and then having the discipline to only make trades when you have edge. That’s the key element here. Small Edge, Small Trade. Big Edge, Big Trade, No Edge, No Trade. It’s not about, I made money (got a hit), therefore, it was a good trade (at bat), or I lost money (got out), therefore it was a bad trade (at bat). It’s more about focusing on the process. Are you doing the right things? Are you swinging at your pitch each and every time? First, you have to know what your pitch looks like, then if you are able to have the discipline and patience to only swing when your trade, when your situation, when your set-up appears, then over time, you will be successful and have profits on the upside. Now that’s something anybody can learn how to do. Anybody can learn how to be patient. Anybody out there can learn how to think about what their competitive advantage is. Anybody can learn how to be disciplined. So when people ask me, “Are people born to be successful traders?” The answer is, no, not at all. These are all skills that differentiate success and failure and the ones that are impactful, anybody can learn to do and bolt in. It might be easier for some people to do because they are born more disciplined or they’re born with a greater ability of self-awareness. But at the end of the day, it doesn’t mean that it’s closed off to other people. These are all teachable skills.
Make sure you come back for PART 3 to be released tomorrow, August 19. You can catch up with PART 1 here.
DISCLAIMER: There has not been and will not be any exchange of compensation for this interview. Dr. Hirschhorn is kind enough to share his knowledge with those who might benefit; therefore, the value is to be determined by its recipients.
