Crystal Clear: Debunking Diamond Hands
Introduction
Earlier this year, we saw a unprecedented new force in financial markets. Day traders banded together on Reddit and effectively moved the market. Cries of “hold the line” and “do not sell” were seen across social media platforms, which helped drive up the stock of GameStop to astronomical levels.
For some of those traders, their trading was ideological- they wanted to burn Wall Street short traders. A diamond hands means a trader will hold until the bitter end- regardless of how risky the position is.
In the Reddit/ GameStop situation, because of the wild swings in the prices, some traders will have massive winning open positions, while others will have large open losing positions. Obviously these traders are not working on any trading strategy, rather they are taking trading positions to make a point, but nevertheless it leads us to think about when our trading strategies effectively have the same outcome – closing very large (relative to the size of our normal trades) wins or losses.
At Chasing Returns we think of diamond hands as outlier trades.
What is an outlier?
In statistics, an outlier is a data point that differs significantly from other observations. When we looked at data for 50,000 traders, we can see how widespread the problem of trading outliers is -over 99% of traders in our study had outlier trades. These outliers have a disproportionate impact on profitability: overall only 25% of our traders were profitable but without any outliers (positive or negative), that number would be 45%.
At Chasing Returns, this insight led us to focus on helping traders to avoid negative outliers. We know that the average losing trader only has to eliminate 2.7% of their worst trades to get to break even. So a trader who has executed 100 trades would have had to eliminate 3 of his worst trades to be a profitable trader. To date, with PlayMaker from Chasing Returns, we have achieved a reduction in negative outliers of approximately 1%. We have accomplished this without any reduction on the positive outliers. Our next goal is to reduce it by 3%, while leaving the number of positive outliers the same.
Every reduction in bad outliers will help with drawdowns. The impact of any outlier on trading capital can be significant, and recovering from a large loss is tricky due to the asymmetrical nature of losses. A loss of 25% of your capital means you then have to make profits of 33% to get back your money. A loss of 50% means you then have to double your remaining capital. Once you’ve lost over half your trading capital, the likelihood of being able to make the money back gets more and more difficult.
Positive Outliers
Positive outliers are the trades that make a trader their most money, so naturally we don’t want to reduce them. However, traders should remember to not just look at the profits themselves, but how they were achieved. Were they part of a strategy, and thus repeatable? Or were they down to luck?
It is important to determine which wins are caused by good luck, as attributing them to one’s skills and expertise can cause over-confidence on subsequent trades.
Traders often think their large winners could be compensating for their large losers, essentially that their positive outliers cancel out their negative ones, but this is rarely the case. This is only true for 1 in three traders, but if you are a losing trader, the odds drop to 1 in 4.
Our brains are not designed for the extreme stress of diamond hands. We will be much more tempted to close the winning ones, while letting the losing one’s continue to grow. This is rooted in behavioural science-human beings are loss averse, so our brains are hardwired to avoid a loss, even if it’s irrational, e.g. not cutting your losses and closing a losing trade, but letting it run, hoping it will eventually become a winner. Many successful trader lose a substantial chunk of their profits doing exactly this.
What can traders do?
To be a successful trader, it is vital you measure and understand how your outliers are affecting your trading outcomes. Here are 3 initial steps to take:
Remember you are more likely to remember your good trades, so don’t rely on memory – track your performance.
Analyse whether your positive outliers come from a strategy, or luck, and be careful not to fall victim of the over confidence bias.
Reduce your negative outliers by 1% to begin with (sign up here for a free trial to see how we help with this )
Conclusion
A diamond hand strategy can seem enticing, especially if you are a risk seeking trader, but as William Shakespeare said, “not all that glitters is gold”. Outlier trades can feel fun and exciting when you are in them, but negative outliers can cost you greatly. By reducing them, you have a clear path to improved trading.