(This is an updated version of a post originally published in March 2013.)
Sometimes, when you’re developing a trading system and you’re looking back through the trades it took, you come to a ‘market event’ type of move, one where we might gap lower, or skid relentlessly, a flash crash, or an actual big-boy crash. One could argue with the S&P 500 closing below its 200-day for the first time in two years we could potentially be entering such a period now, one that presents you with signals and opportunities in a fast market.
Whatever it is, we nonchalantly assume, yes, we would have taken that signal. Maybe you would, but as much as it’s necessary to lay down rules and guidelines in trading, if they’re in any way ambiguous or unrealistic, you risk leaving room for error, lack of discipline, or departing from your process just when you need it most.
I’m always flattered when a young trader will ask me for advice or be keen to show me their trading system, which they demonstrate to me via this absolutely perfect equity curve, as smooth as you can imagine. It’s obvious it’s been optimized and it will include trades they supposedly would have taken in the 1987 crash or in the fall of 2008.
In reality, not only might they not have taken the trade, but even if they did they may not have been able to execute it given the market conditions that existed. You just can’t recreate that stuff in a backtest. You also can’t recreate the fear, the panic, or the emotion, so you can’t know for sure you would act on a signal until you actually have to.
When I try to tell them that, it reminds me of a scene from one of my favorite movies “The Bridge On The River Kwai” where Jack Hawkins tries to recruit a young soldier but doubts his ability to execute under pressure. Here it is:-
These gentlemen are thinking of taking you for a little hike into the jungle.
– Yes, sir.
You were an accountant in Montreal?
– Yes, sir. Not really an accountant, sir. That is, I didn’t have my charter.
Exactly what did you do then?
– Sir, I just checked columns and columns of figures which three or four people had checked before me… and then other people checked them after I had checked them.
Sounds a frightful bore.
– Sir, it was a frightful bore.
How did you wind up here?
– Sir, I came over to London to enlist and about two years later, I volunteered for this work.
– Yes, sir. You see, the regular army–
Go ahead. You can be frank.
– Sir, the regular army sort of reminded me of my job in civilian life. They don’t expect you to think.
Think about this. (Holds up knife with huge blade)
Are you quite sure you’d be able to use it in cold blood?
– I know how to use it, sir.
That’s not what I meant. Could you use it in cold blood?
Could you kill without hesitation?
– That’s a question I’ve often asked myself, sir. It’s worried me quite a bit.
What was the answer?
– I don’t honestly know, sir. I’ve tried to imagine myself–
– I suppose I find it hard to kid myself that killing isn’t a crime.
It’s an old army problem. I think that’s all. Thank you, Joyce.
– Am I to go with the team, sir?
We’ll let you know. (Joyce leaves the room)
Now you see what I mean?
At least he was honest about it, sir.
None of us ever knows the answer to that question until the moment arises.
Fortunately for Joyce, Capt. Shears did know the answer and took great pleasure in executing his duty when the moment arrived…
Could YOU take that signal when the futures are limit down, when your stop is breached, when all seems lost?
Could you kill that loss in cold blood?