The Billion $ Trader, With No Overnight Positions. - How Time of Day affects Trading Quality.

A few years ago, I met with a new client at a hedge fund. This individual defied every stereotype of how one might assume a hedge fund portfolio manager may be. He was a highly nervous and anxious individual. Unlike many of his colleagues at this fund, who mostly took medium-term relative-value type trades or long-term macro positions, this individual day-traded FX, something generally assumed the domain of the home retail trader. What was more remarkable however was his incredible track record. In a typical year he made around USD 40-50 mio of profit, approximately a 16-20% return on capital, though for reasons which will become apparent, this understated the strength of this returns. That year he had made around USD 100 mio, a large chunk of it in the space of a few moments when the Euro v Swiss Franc FX rate plunged after the Swiss National Bank pulled its peg versus the Euro. 

What really stood out for me though, was that this London based trader never traded or carried any positions after 1pm UK time. I asked him, “What if you have a strong signal in the afternoon which suggests taking action, wouldn’t it mean that you will be leaving money on the table by not doing anything?” He said that often it was the case that he had good signals in the afternoon, however his performance record keeping and analysis of his trades suggested strongly that he was better not to act. He said that over the years, there is an increasing divergence between what his system says he should make, and what he actually makes as the day wears on. He said that historically his afternoon trading provides him with a net loss, even if you included the trades that made money on strong signals.

This fascinated me because it was a live example of a theory that I had about afternoon trading. This theory was formed from research I had read about and my own trading experiences over many years. The theory argues that our ability to make effective decisions and to exert self-control in our actions diminishes the longer the day goes on. In a trading sense this suggests that 'whilst a trader may have an edge early in the day, that edge often erodes throughout the day to the point where it turns negative'.

Decision Fatigue, Mental Bandwidth and Trading

The research which led me to this belief was produced by a group of psychologists who had analysed the decision-making performance of parole-board judges. The research looked at the time of day of decisions to grant or deny parole of over 1000 cases over a period of nearly a year. The decisions were aggregated and placed into a single time of day chart. This chart can be seen below:

Source: Extraneous factors in judicial decisions https://www.pnas.org/content/108/17/6889

A positive (considered a good choice, since each individual up for parole was believed to be there on statute and merit) was given a score of 1, a sub-par choice ‘denying parole’ was given a score of 0. The quality of the choices can be seen to deteriorate as the day wears on, and indeed as each section of the day wears on without a break. only improving for a short period after intraday breaks.

This research highlights the role of ‘Decision Fatigue’ in people’s decision-making. The mental work of ruling on case after case, whatever the individual merits, wore the judges down leading to lower quality decisions as the day moved on. This sort of decision fatigue makes people involved in repetitive high stakes decision-making prone to dubious choices as the day progresses.

This sort of fatigue differs from ordinary physical fatigue where you are conscious of your tiredness. With decision-fatigue, your mental bandwidth is stretched, but you are not conscious of it. Thus, you carry you carry on making decisions and choices regardless, though you are not aware you are more prone to making progressively lower quality choices.

Decision fatigue manifests in many ways, however some of the most familiar to traders will be:

• Acting impulsively instead of expending the energy to first think through the consequences. We see these in knee-jerk trading responses, and unplanned reactive trades. 
• Straying away from your method or system and the processes which are part of it. 
• Random or boredom trading. 
• Failing to remain disciplined, and trying to finesse your trading.
• Decision avoidance: not taking an action but procrastinating or hesitating.
• Greater vulnerability to our natural human biases. 

Day Trading in FX Trading Markets.

The following chart looks at the percentage of trades in five currency pairs that closed with a profit at broker FXCM from 10/01/2009 to 09/30/2010. I have assumed that most of these trades refer to day trading clients.


Source: https://www.dailyfx.com/forex/technical/article/special_report/2013/01/24/forex_education_do_hours_i_trade_matter.html

The most profitable period of the day was from midnight to around 5am NY Time. This is around 6am to 11am Central European Time. Since by far the highest proportion of Forex trading occurs in the European time-zone, this suggests that most Forex traders were profitable in the first few hours of their trading day. However, as the day progressed the trader’s profitability levels drop. Levels of profitability appear to return to balance late in the evening, which one presumes coincides with most Forex day traders having packed up as European and East Coast US markets close and the day moves into the lower liquidity Asian/Pacific time-zone.

Whilst there may be many reasons for this pattern in FX day trader's performance, I'm hazarding a guess that it suggests there is some credence to the possibility that ‘Decision-Fatigue’ could be at play.

A Good Night's Sleep and Decision-Making.

Returning to the story of the fund trader. Seen in this light, his practice of not trading into the afternoon seems a wise one. He is a seasoned trader; he knows when he is strong and when he is compromised. He knows he has no edge in the afternoon so why play when you have no edge, for him it was just playing to lose.

This story has further implications, since it also alludes to the benefits of a good night's quality sleep. We all know how grouchy we are when we had a poor night's sleep. But what we don't consider how we are likely to make sub-par decisions after a bad night's sleep. I know some traders, who won't trade at all if the quality of their sleep was poor. For them, their edge is lost even before the day starts. 

This concept of decision fatigue does not just lend itself to day-trading. I once read how Warren Buffett said he never makes big decisions late into the afternoon. His view was that if a decision is that important, sleep on it and consider what it is like in the fresh light of a new day.   

This is an updated version of an article originally produced by Steven Goldstein of AlphaMind for FXStreet. 

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GBPUSD FX trade idea, set-up and some trading psychology.

Occasionally I like to look at and write about what I view as favourable trade set-ups. This year, I have only documented a few, however most of them have had a good record, even if timing was not quite right. My favourite calls this year have been long USDJPY at the start of the year, though on the trade I had on, I took profit too early, though I wasn't complaining about an 8 big figure gain. I also have been long USDJPY since late October and remain so, with a 'in the money' trailing stop guarding it. Another trade which worked well for me earlier this year was long EURNOK, though I don't think I documented it in this blog, it was mentioned in this article here (See performance coach, championing it as a trade). I also dabbled in AUDUSD, calling the bear early in the year, and the recovery a little later, though my timing was slightly out, and I traded it far worse than I analyzed it, which has always been my challenge as a trader. Overall I'm glad to say that my trading account, which is merely a hobby for me these days, is significantly onside,though some ugly attempts to get in and out markets at times, usually in EURUSD have helped erode gains somewhat.

Now I think I may have found another trade I like. - Long GBPUSD spot (or Cable as us FX types call it.)

First let me sum-up my usual formula for identifying what I consider as potential good value trades: I don’t tend to base my view from fundamentals, though I like to consider fundamentals in the equation when I feel I have a good view of them. My preference however is to look at a set-up technically, if I like it I then look at the risk reward, is it favourable relative to where a stop would be and to account for the volatility of the market?  If it has what I consider a decent fundamental case to back it up, then even better.

Currently the long GBPUSD for me largely fits this set-up, I am not altogether sure of the fundamental case, after all both the UK and US currently have recoveries, if only modest ones. Like most trades, I am sure if I need to then I could fit a good supporting fundamental argument later, if it goes the right way!!!

Technically there are a few things I like about this trade:

1) The 'Failure' of the multi-year 'Bear Triangle' to follow-through on a downward breakout and the subsequent reversal: I love failures, people rarely look at them, they prefer to look the other way for completions and continuations, but failures can be great trading set-ups, and few are better than Triangle failures. The fact that it has broken through the top side of the triangle line, now adds to this. Potentially failures can have very sharp and relatively quick reversals which can move far further than people often consider. The long-term weekly chart below shows this clearly.



2) A Weekly 'Bull-Flag' formed over recent months: The breakup of the Bull-Flag has coincided on the move above the top line of the large triangle. This projects, using traditional technical analysis measures, potentially to around 1.7600ish and change.

3) An shorter-term (Using the 4 hourly chart) 'Bull-Flag', formed over the past couple of weeks.

One final thing, which is interesting; note the similarity of the above two charts, this year's weekly chart, and the lower 4-hour chart. Its almost like there is a fractal relationship, where the lower chart is repeating the set-up of the above chart. It could be merely be co-incidental, I may be looking for patterns within patterns, where none really exists, however I have seen similar market price action in the past, which have as I recall occurred prior to large moves. (Psychological point: I may be accessing selective memory and recalling a situation to fit a desired outcome, that is one reason I use protective stops.)

Psychological perspective: As this blog is principally about the psychology of risk and trading, and as a trading coach working to help enhance trader performance, I thought I'd add some psychological perspectives: In this case I would like to talk about some of the major 'Cognitive Biases' which affect traders, and how this could impact my performance on this trade.

- Loss Aversion:  We are all prone to Loss Aversion; Loss Aversion is a feature of who we are, not a flaw in our make-up, as some people seem to think. Loss aversion is basically our innate need to avoid losses rather than seek gains, as such it biases our behaviours in certain ways. The most common affect seen in trading is to run losses, so as to avoid crystalising them, but to quickly grab at gains, thus locking them in. Hence we make small gains and suffer large losses. This behaviour can be highly destructive to managing a trading book or portfolio, in my own trading I try and put trades on with a favourable risk reward profile so as to help counteract this bias, and always use a stop to protect my self from running losses.

In the above trade I have placed the stop a little below last week's 1.6290 low, adding some room to avoid getting hit by stop hunters. I have a target around 1.7000, this means currently my risk reward on this trade is potentially 3.5 to 1. A very favourable return. I have also entered a risk amount equivalent to about 2% of my trading capital, thus I am unlikely to have highly elevated emotions driving my behaviour. We are more likely to fall victim to basic destructive default behaviours, such as loss aversion, when we are more emotionally charged: Having too much at risk, relative to capital can cause this. On the other hand if I am right, on this trade (And remember there are no guarantees) then I could return about 7% of my capital.

- Over-confidence/Over-optimism:  This might seem slightly odd, here I am talking about our natural aversion to losses, which seems a little 'Cup Half-Eempty' and yet at the same time we are bias to believe in rosy outcomes, i.e. 'Cup half-full'. Research after research shows that we are mostly over-confident in our belief in our own abilities, and over-optimistic that the future will be bright. This is not necessarily a bad thing, one needs a high degree of confidence and self-belief to be successful and to keep coming back when so often beaten up, as markets can do. However, the ying to this yang, (or is it yang to the ying!) is that many traders immediately discount a favourable outcome to their trade, and possess over-confidence in their ability to forecast the market. As a consequence they may take a larger risk than maybe prudent.

I am no less vulnerable than the next person when it comes to over-confidence and over optimism, as I said above, these are features of who we are rather than flaws in our character. However, it is good to be aware of these, and to understand how they can damage your performance. - In order to help overcome or offset this bias, having a structure to how you take risk is important. With regard to my trades, I carefully set my trade size relative to capital, this ensures that I do not over-expose myself, in addition I also size my trade relative to how much I am willing to lose, not to how much I expect to make. Note, I am a firm believer in adding to the trade if it moves in my favour, if that happens in this trade, I will look for favourable risk-reward areas to add value, using gains I make along the way add leverage.

- Confirmation Bias: This is another significant and potentially damaging cognitive bias which we are all vulnerable to; it is something I have been particularly susceptible to in the past. (These biases don't go away just because you know about them). Confirmation bias is where we try to prove our point, or back up a belief we have by seeking confirming evidence. The danger with this; people close their eyes and ears to potentially conflicting evidence, sometimes digging their heels in and becoming stubborn in their beliefs. One step to helping offset this is to investigate one's intuitions and analyses a little more deeply, taking a more objective perspective, and perhaps even trying to disprove one's views. Sometimes trying to disprove a view can make it more robust. Of course this is not foolproof, we are all 'blind to our own blindnessess', and as mentioned above, prone to over-optimism.

In the above trade, I started by a taking a quick look at the 4-hour chart, I liked what I saw. Then I felt I needed to look at the longer term charts in order to see how it looks there. I first took a slightly longer view, the weekly chart, then looked at the much longer charts. In both cases I actually felt more convinced the trade was right. This was a simple trade, and that description, I admit is pretty simple, but that kind of sums it up.

- Finally my philosophy: 'I could be wrong, and if I am , then so be it'. Trading requires losing in order to win. Accept that you could be wrong, it helps!