In part I of the MT Driver’s Manual we introduced the driving analogy, to clarify a sense of the Mercenary trading style.
In part II we discussed the four components of a trading program – areas that traders must think through in designing a complete methodology, regardless of style or time frame.
For part III we’ll delve into Selectivity & Spread – two cornerstone concepts of our discretionary trading approach.
As we later drill down into the details of position sizing and portfolio management, Selectivity & Spread will help tie it all together.
Before defining the terms, it should be noted that the discretionary trading process and the mechanical trading process are in some ways very different.
By “mechanical” we mean automated, rule-based trading approaches, e.g. system-based day trading or computerized trend following programs.
Many mechanical traders follow the belief that trading size (and trading frequency) should be uniform. By this school of thought, you simply set up the rules and follow them – in a sense, flipping a switch and letting the program run.
The discretionary approach, in contrast, is quite different – at least the way we apply it – and is more oriented toward the old Soros paraphrase: It’s not whether you are right or wrong that’s important, but how much you make when you’re right, versus how much you lose when you’re wrong, that counts.
Michael Marcus, one of the original Market Wizards, talked about entering with five or six times the size on the trades he felt most strongly about.
Randy McKay, another Market Wizard, discussed varying his trading size by a factor of as much as 100 to 1, going from hundreds of contracts when hot to just a few contracts when cold (and then back again).
Selectivity & Spread is our label for this critical aspect of discretionary trading. So now let’s go ahead and define the terms:
- Selectivity refers to variation of trading frequency in diverse trading environments. A trader with high selectivity will be extremely active in “target rich” trading environments (as defined by custom standards), yet notably patient and conservative in “target poor” trading environments (when risk levels are unacceptable and / or opportunities are thin).
- Spread refers to variation in position size from smallest trades to largest trades. A trader with a high spread quotient may vary the size of trading positions (in respect to planned risk) by orders of magnitude over time (especially in a total exposure context).
The key factor here is fluid response to varying market landscapes. At different points in the cycle, the activity levels and exposure profiles of the skilled discretionary trader will look very different.
This idea is somewhat analogous to “shifting gears” at the poker table, a concept we’ll return to time and again.
Great poker players do not get locked into one style of play or bring the same activity level to every session, because every session is different.
Sometimes it makes sense to be cautious and conservative for long stretches. Other times – and much more selectively – it makes sense to be ruthlessly aggressive.
You can’t make blanket statements about a great poker player. On some nights it’s, “He’s super conservative. He’s a rock. He only plays premium hands.”
On other nights you see the exact opposite: “He’s a bully. He’s a maniac. He seems willing to play any two cards.”
Conservative rock, aggressive maniac, loose and engaging, quiet and seemingly withdrawn… the great player is all these things in turn. He exploits the present environment with maximum adaptability, and does not hesitate to reduce risk via reduced activity. That is Selectivity & Spread.
To further grasp this concept, imagine a player with zero selectivity and zero spread.
In poker this would be the guy who plays the exact same way, every session, all the time. Sometimes the style and the environment sync up nicely. Other times it’s a horrible mismatch. But every session the approach is the same — to sub-optimal long-term result.
In markets, a trader with zero selectivity and zero spread would make the same number of trades, using the same static position sizing metric, month in and month out.
As mentioned, this may be the optimum for certain mechanical approaches. But it’s not the discretionary way.
So why are Selectivity & Spread so important?
Let’s stay with the probability-based world of card games for a bit longer – particularly blackjack and poker.
These are virtually the only two games in the casino that can be beaten with skill: Blackjack via concealed card-counting techniques, and poker via besting one’s opponents.
In blackjack, card counting teams succeed by dramatically varying bet size.
In casino terms, the designated player waits until the deck is “rich in aces and tens” (face cards are worth ten points) – at which point the big bets go down.
Or, as Danny Ocean put it, “Play long enough, you never change the stakes, the house takes you. Unless, when that perfect hand comes along, you bet big, and then you take the house.”
If you can understand intuitively why card counters dramatically increase bet size when the odds are in their favor – and why they can make millions of dollars doing this – then you have the gist of Selectivity & Spread.
(Of course, if the casino catches you counting cards, they are likely to beat you up and throw you out. There is no equivalent skill penalty in markets.)
In poker, the same concept emphasizes conservative aggression. As Larry Phillips points out in Zen and the Art of Poker, the skilled poker player knows how to “use inaction as a weapon” – a sort of zen baseball bat used to club one’s impatient opponents.
When aggression is used selectively rather than indiscriminately, Phillips further notes, the hands you play aggressively tend to stand out for their clarity and power. That too encapsulates Selectivity & Spread.
A few general observations:
- It’s perfectly okay to trade small for long stretches of time. For impatient traders, trading small often feels like a waste. What’s the point? But there is a lot of value in trading small, and keeping exposure limited, during those periods when opportunities are scarce. Trading small is also a great way to jockey for position, build a feel for current conditions, and otherwise cultivate the presence of mind necessary to know when it’s time to trade big.
- Starting small – with low levels of gross exposure – allows for greater contrast between low conviction periods and high conviction periods. Trading, like poker, allows for the ability to dial up or dial down exposure. You can have a little bit of skin in the game, or you can have a lot. How much would your results improve over time, if you managed to have a lot more exposure (on average) when things are hot, and a lot less when things are cold?
- There is a time to “back up the truck.” Our friend Peter Brandt, a veteran trader we deeply respect, has a truck-beeping noise he likes to play when the big trades come. George Soros, one of the great speculators of all time, is known for “going for the jugular.” Point being, there are definitely times to “go big,” and a key point of Selectivity & Spread is preserving both mental and financial capital so one can act in full measure at those times.
- Gaging conviction and assessing market conditions is a performance-enhancing habit. To make the most of Selectivity & Spread, you have to know what a target-rich market environment looks like. You also have to know what a target-poor market environment looks like. Furthermore, you have to have a clear sense of what counts as a high conviction trade and what doesn’t. And most importantly, you have to develop an intuitive feel for the relative frequency levels of high conviction versus low conviction trades, as applied in your particular style of trading. All these areas improve with observation and practice.
Next time we’ll talk about position sizing basics…
Next up – Standardized Units of Risk
p.s. As with so many other elements, we feel that “learning by doing” is the most effective path to mastery.
To that end, you may benefit from seeing Selectivity & Spread (along with other core trading concepts) applied day-to-day in the context of a real trading portfolio.