Random rewards and hooked monkeys

Mark Douglas brings out some interesting concepts in Trading In The Zone. One of the things he talks about is effect of random rewards. If you teach a monkey to do a task and consistently reward it every time the task is done, the monkey quickly learns to associate a specific outcome with the efforts. If you stop rewarding it for doing the task, within a very short period of time the monkey will simply stop doing the task. It won’t waste its energy doing something that it has now learned it won't be rewarded for. However, the monkey's response to being cut off from the reward is very different if you start out on a purely random schedule, instead of a consistent one. When you stop offering the reward, there's no way the monkey can know that it will never be rewarded again for doing that task. Every time it was rewarded in the past, the reward came as a surprise. As a result, from the monkey's perspective, there's no reason to quit doing the task. The monkey keeps on doing the task, even without being rewarded for doing it. Some will continue indefinitely. I think it’s very true even of humans. And this problem gets even more exaggerated in trading.

Suppose you observe some setup. When you trade it, there is always 50% chance that it will go in your favour. Now, that’s random reward. When a trade goes in the money you never know if it was because of your analysis or it was pure randomness. What makes things even more difficult for a trader is the “experiment” (the trade in this case) can rarely be reproduced because of dynamic nature of markets. Markets never provide exactly same conditions. For example, for a currency pair it’s it extremely difficult to find exactly same conditions at two different times. Within a day, for example, a pair will behave differently at different hours. Market characteristics will change dramatically as major markets open and close. Next day, obviously, very different conditions will prevail.

How does one, then, know if a particular setup is indeed working and rewards are not random. One solution is to be extremely skeptical of any results. For example one may reject anything that gives less that 80% positive trades. Another option is to be very specific about market conditions where a setup is applied so that trade can be reproduced with little variation in conditions. No surprise then, I have seen some accomplished traders using these techniques. One very good trader recently told me that any trade that goes against you even slightly is bad trade. That’s some strictness! But that was not all. Oce he suggested a trade and went on to add that trade expires in 15 minutes- meaning if entry trade is not activated in next 15 minutes don’t take the trade. No wonder, he has been exceptionally successful in filtering what works and what doesn’t work in trading.

Desclaimer: http://indiangridlock.blogspot.com/2010/12/disclaimers-for-all-posts-in-this-blog.html

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Profits, Losses and Nonsense

If you have been trading for some time then you must have heard someone talking about risk/reward ratio. In simple terms it is same as ratio of your stop loss/ take profit targets. It is often suggested by many that risk reward ratio of a trade must be Low- sometimes 1:2 is thrown as a rule of thumb. This means your TP should be twice of your SL How does one then explain many great traders not believing in concept of stop loss. (In case you are scratching your head, pick a copy of “one up on wall street” by peter lynch or “ bird watching in lion country” by Dirk Du Toit)

Job of a trader is to generate positive cash flows. Mathematically a trader should be solely concerned with “expected return” of the trade rather than individual components that determine this. One must optimize expected return rather than stop loss or take profit or their probabilities. For any trade,

Expected return= Probability of TP x TP- Probability of SL x SL

TP= Take profit, SL= Stop Loss

Logically, one should take a trade if this expected return is higher than costs incurred in trade( brokerage etc). (One must also consider, risk adjusted return.). Now if we assume random movements in markets then its easy to see that risk reward ratio has no bearing on expected return. In fact, no matter what ratio you use you will end up losing exactly brokerage/ spread. Increasing TP will only reduce probability of TP and increase probability of SL- linearly without giving you any advantage. So, concept of risk reward ratio is inherently useless in this case.

But traders don't believe in random walk or efficient markets or else they won’t be trading. There are few who believe in “momentum trading”. They believe that once a movement starts it will continue in same direction for a long time. In this case, it becomes very obvious that small risk reward ratio will give you enormous advantage because probability of SL and TP remains same irrespective of their levels ( 50%?). Once markets starts moving in your direction they will hit TP. Else they will hit SL irrespective of their ratio.

Then, there are traders who believe that markets have their own rhythm and they cannot move unidirectional. This means after every move there is correction and retracement bringing prices to a mean level. These traders will obviously believe in keeping very high sl/tp ratio. These are the kinds who say markets dont go anywhere. Mathematically what they mean is as SL becomes large, probability of it being hit falls not linearly but exponentially giving you an edge with large SL.

But who of these two are correct? I fired up my simulator this weekend to test these theories. (I used randomly generated trades with different risk/ reward ratios for last 20 years of hourly majors data ). As it turns out, High risk reward ratio maybe BENEFICIAL in short term and in ranging markets. However over time, the edge disappears and none tend to be correct in their beliefs. Random trades will lose money irrespective of risk reward ratio, although a HIGH risk/reward ratio will result in longer survival of the account.

Naturally, if trades are not random then results change dramatically. So it's not about risk reward ratio- its about your analysis. Worrying about TP and SL ratio will only give you headache. Observe, analyze and trade. If your observation is good you will make money else you will lose money. Trading is as simple as that. Anyone who talks jargon ought to get his facts right.

Afterthought: Ideal solution to this dilemma would be to somehow determine if markets are going to be range bound or moving directionally. Then one can shift one’s strategy to gain maximum advantage from probabilities.One such tool to determine market activity is Elliot wave analysis that tells you to keep low risk reward ratio in wave 3 and wave c. In other waves keep large risk reward ratio. No wonder most of good traders use some form of market structure analysis ( if not Elliot wave).

EDIT: I have found some interesting patterns when trades are non random. I found high risk reward ratio might actually be good. I took few momentum strategies like fractal. (Buy when daily high fractal breaks, exit at close of bar- very successful in moving majors like eur,gbp yen etc).Now, interesting part is even with this momentum strategy as you increase your sl pnl improves. For EURUSD, As sl approaches 400 pips, maximum pnl is achieved and thereafter there is no further improvement in pnl- again 20 years daily data. Yet to do enough analysis. Will need to go deeper. Meanwhile found an interesting analogy to myth of risk reward ratio- A roulette at the casino gives you a 35/1 risk/reward situation, every dollar you wager could bring you $35. So your risk here is "only" $1 but your profit (if your number comes up) is $35, a very good risk/reward scenario indeed.

Dealing with mobile Spam

Nuisance of mobile Spam is getting worse everyday. Here is my way of dealing with it if you want to save some harassment to yourself.

A. Nokia provides in built powerful call filtering functions, which I was not aware of until recently. Basically you need to make different “contact groups” of people whose call you would like to take urgently (Contacts> contact groups). For example make a contact group named “Meeting”. Add all the people whose call you would like to take even in a meeting. Next, Create a new “profile” and name it say Meeting. Now when you set different parameters for the profile, you can specify weather the phone rings for all calls or only for certain “contact group”. Deselect “all calls” and select the specifically created contact group Meeting. Set the tone or maybe vibrate only or beep once in tones section. Now you are ready to use the profile. When you step into a meeting just change your profile to meeting. You phone will ring/ vibrate only if someone from the contact group Meeting calls you. Fr all other calls it will remain silent. Later, you can check missed calls and call them back. You can create multiple profiles like this for every situation- sleeping driving or just pissed off. You can also make a contact group called known numbers and add all contacts there for use when you want to receive calls only from known numbers.

Note: In some new models, Nokia has made it difficult to add multiple contacts to contact groups. You have to select each contact one by one. You can also try PC suite to set up the contact group.

B. Try registering with national do not call registry. SMS to 1909 with keywords 'START DND' for registration. If you are being harassed by some specific company try and see if their website has a link to deregister from their database. Most of the irritating banks have a link on their website to stop them from calling you. These measures are rarely useful. But I still recommend it. It will have some minor effect at least. And in any case after registering in do not call registry if you still get a call, the caller is on wrong side of law, which can be useful.

C. Finally, for most paranoid amongst you, try using Spam software. To deal with SMS Spam I use Best Spam killer by smartphoneware. I have set it to filter all messages from unknown numbers unless they contain specific keywords like “ Account credited “ :)

To Avoid call Spam, I used to use Mobisy’s spam manager (Freeware). Basically once you add a number to its list, whenever that number calls you, Call will be automatically rejected- it wont ring / show in missed calls. He will hear “this number is busy. Please try again later.” You can later check the log of rejected calls if you wish. (I was very hesitant to disclose this software. Anyway, lets hope some people never read this blog lest they figure out why my phone is always busy) However recently I have switched to ballballer blacklist lite. It serves the same purpose with additional benefit of in built database of Spam numbers for your country. When a known Spam numbers calls you, it’s supposed to warn you. Am yet to receive many Spam calls after installing it. So, can’t comment on its effectiveness. Note that this one is not as fast as mobisys in rejecting calls. The caller actually hears one or two rings before call is disconnected. So it may seem to him that you have seen the call and then disconnected. Note: I am using these software on symbian. However, most of them have android, iphone and blackberry versions.

Together, these steps should make your life much more productive. However always be aware that Spam filtering is double edged sword and if you become too aggressive you may miss on some extremely urgent calls. Use these tools with discretion. You don’t want to miss your family’s frantic calls from a PCO. And you don’t even want too miss you Bais calls to wake you up when you are oversleeping.

Getting a passport in mumbai

I don’t like to visit government offices but was forced to do so recently. Primary motivation was constant hassle of proving my identity and address. I have quite a few documents but some offices will accept only passport or ration card (don’t be surprised- Indian government still issues ration cards to distribute whatever grain doesn’t get rotten after rains). So I started on a crusade to get my address changed in passport. Unfortunately my earlier passport was from Kolkatta so I had to go through entire process of a new passport in Mumbai. Here are details of process for those who might need the info in future.

First thing I did instinctively was to google for any info that might be available on net. I found a few nice blogs and also “online passport website” of government of India. Obviously I was pleasantly surprised to find Indian government Online! I immediately checked the website and found that online application is possible only for issue of new passport / reissue. Idiots like me who wanted to get foolish things like address updated must go and burn in the Agni of great Indian bureaucracy. Motivated by possibility of avoiding babus and chaparasis, I decided to wait till I was eligible to apply for reissue of passport (That’s one years before your passport expires. I just happed to be lucky that my passport was expiring soon). On exact date when I became illegible, I applied online for reissue of passport. When I finally finished the online application I almost cried with joy. Not only I was given very clear instructions on which documents to bring but I was also given an appointment time in passport office so that I wouldn’t have to wait in those long queues. I reported cheerfully with documents to worli passport office on given time. But alas! That was territory of babus! I was flatly told that the appointment time given in acknowledgement from the website was only for decorative purposes and I would have to join the long queue like everyone else. Since I know better than arguing with government chaps, I joined the queue and waited for two hours before the great moment of appearance before the passport clerk came. Next was another well known trouble with government clerk- The lady there told me that no matter what was written in her ministry’s website I must bring two of the documents mentioned in list instead of one to prove my address. I have many bank accounts and I produced account statements from 3-4 banks. But she told me only state bank account statements are considered a valid address proof! Luckily I had one state bank of travancore account from my college days. She didn’t notice travancore and was impressed by state bank logo. But I still had to submit another proof as per her rules. When I told her to give in writing that the website rules don’t apply she simply managed to find some stupid typo in my application and rejected my application on that basis. Having wasted my 5 hours and wiser by years, I headed back to office.

Better informed now, I again applied online for a fresh appointment and insured no typos this time. I also arranged to get a leave on that date so I can devote entire day to the serious business at hand. This time I was certainly better prepared. I packed a huge folder with every possible document with my address in it. In addition, I packed myself well for the battle ahead- few horlicks bars, water bottles, umbrella, all sorts of stationary- blank papers, photographs, scissors, glue etc, And finally few nice thick novels. I started early in morning only to find myself in after 100 odd people in the queue. Somehow, I was called before I ran out of my stock of water and food. I presented my case to the clerk and started throwing various address proofs one by one at him. But this clerk found it amusing and told me that all those documents were not needed and whatever I had given in the beginning was perfectly fine! Maybe speed with which I started throwing documents had a shock effect J Anyway this chap turned out to be extremely professional and quickly finished the scrutiny. Then I was directed to join another queue where fees were to be deposited. Unluckily for me the ancient computer in the counter breathed its last just when I was to submit my fees. That accounted for another 30 minutes of misery but finally I emerged victorious from the battle. War, as they say, was a different story.

Out of passport office, I proudly took out my fees receipt (making it a point that unfortunate ones still waiting outside in queue see it and burn with envy). Surprise again- helpline numbers of both passport office and mumbai police are printed on receipt to check status of police verification and passport issue. That’s some mix of professionalism and babuiri! Anyway, after few days I checked online and got to know that my file had gone for police verification. So I called the mumbai police help line from the receipt. Few hiccups and finally the lady there manage to figure out that my file had gone to andheri police station for verification. Since the file had already been rotting there for 10 days, next day I visited police station for enquiry. The chap in charge there turned out to be quite nice and told me that he will send someone that day itself. And sure enough shortly came a havaldar to my home and made serious inquiries indeed. He even asked neighbors and security guard if I stayed there. Satisfied that I had little probability of links with terrorists, he issued a challan to me. The challan instructed me to come to police station with documents within three days. Next evening I visited the station as per time mentioned in challan. There I notice a huge board telling everyone to visit only between 10:30-1:30 in the morning. So, next day I took passport leave number two and presented myself to in-charge there. He was very amused that I had submitted only two documents at passport office. Not satisfied by my argument that no document was needed for re-issue, he told me to bring telephone/ electricity bill. Since I had already taken leave for the day to take care of such contingencies, I had no difficulty in satisfying his requirements. Once he was happy with my telephone bills he finally approved my file and told me to appear for “interview with bada sahab” next day evening. Luckily for me, the time he gave was 830 so could manage without a leave. Next day, I found a motley bunch of people waiting for the mysterious interview with bada sahab. Soon my turn came and I had to go and tell bada saab my name, date of birth and address. Satisfied, he put some ticks on file and signed it and I returned home happily. Think once passport office gets police verification they will issue me a passport. But you never know how Indian government can surprise you. So keeping my fingers crossed and praying to hanumanji everyday morning for now.

The senseless blackberry controversy

Suddenly the eternal debate between privacy and security has found itself in focus after some governments have suddenly seemed to have found a new security threat- humble blackberry. Of course, public is whole heartedly supporting governments- The word “security” has magical effects.

I personally think this latest controversy is essentially a hoax. Governments are simply misusing people’s lack of understanding of how encryption works to stroke public outrage. What essentially is encryption? Any information is a number for computers. Everything is saved as a sequence of 0 and 1. Now when you encrypt something you provide the data and a password to encryption software. The software simply performs complex mathematical operations on these two “numbers”. For simplicity sake lets say the original data is 10 and you provide password 8. Let’s take a very simple encryption. Say, we raise 10 to power of 8 and store the result 100,000,000(in binaries). Now, this stored number is utterly unless you know the password and mathematical operation that was performed on data. If you know that, then you simply take 8th root of 100,000,000 and get the original data as 10. If you don’t know the password, knowledge of encryption algorithm only is useless. In simple terms, x (data) y (password) =z (encrypted data). If you have only encrypted data, z then there is no way to know original data x without knowing password, y. Of course, modern encryption algorithms are much more complex than this simple example. That rules out any way to mathematically solve the equation to get possible pairs of x and y.

When you send sensitive information over internet/ mobile network, the data is routinely and automatically encrypted (without any password from you). This is to protect against hacking attacks to steal data before it reaches the intended recipient (Notice https instead of http in secure WebPages?) Once your data reaches the target server, it is again decrypted and stored securely. If blackberry is forced to share its encryption logic, the security agency can intercept and read data sent by users. Or maybe blackberry can give access to decrypted mails on its server. I am not sure of technical details of how blackberry stores data. But in essence what security agencies are trying to intercept is the communication that has been sent in good faith by user without any encryption by user himself.

Surprisingly, to circumvent security agencies armed with blackberry encryption codes is hilariously simple. Those who don’t want their communications to be sniffed will surely not rely on routine automatic encryption. They can simply encrypt the data using their own password before sending it. There are many softwares freely available to do this (TrueCrypt is a good one. You can Google it). What is happening is you are sending encrypted data z (100,000,000 instead of 10) to begin with. Blackberry will encrypt it again to say q and security agencies can again “decrypt” it back to z. But that doesn’t help if z itself is encrypted and is useless without password. Is there any way security agencies can still sniff out original data x (10) from encrypted data z (100,000,000)? NO. Without knowing the password there is no way. Only possible way is what is called brute force attack- trying to guess the password by trying out all possible combinations of keys. But a strong password and that method will take years (maybe decades for 256 bit encryption) even for supercomputers to crack. And then certain types of encryption, by their mathematical properties are immune to even this attack (http://en.wikipedia.org/wiki/Brute_force_attack ). Not surprisingly, security agencies (not only our technologically challenged police, but also FBI) have failed time and again to crack encrypted data. (Not convinced? Here are the examples- http://g1.globo.com/English/noticia/2010/06/not-even-fbi-can-de-crypt-files-daniel-dantas.html, and http://www.infoworld.com/d/security-central/red-brigades-pda-highlights-encryption-controversy-298?page=0,0 )

So what’s all this hue and cry about? I think it’s simply a backdoor entry for governments to private communications of unsuspecting users. Those who don’t want their communications to be intercepted (terrorists/ criminals) will be encrypting their data before sending anyway. Only loser is innocent end user. If any techie can give more insight on it please comment.

Pride and politics of power

Am writing after a long time primarily because of lackluster stock markets and also because certain changes taking place in my personal and professional life have kept me fairly occupied.

From main city I have recently moved to a rented flat in outskirts. The other day I had a minor argument with secretary of the housing society and found it immensely interesting that instead of replying to my objection he smugly replied “aap naye aaye ho yaha. main 40 saal se rah raha hoon.” (You are new here. I have been here for 40 years now). I found it funny because I don’t find anything to be proud of in staying in same house for 40 years. If you ask me, it’s a matter of shame. It might actually mean you are a loser who has achieved nothing beyond what his parents left him with- not even a better house.

False pride is one of the biggest curses of humanity. While ego might be natural instinct, I think people who draw power from our blotted pride carefully keep it alive. Governments, politicians, religious leaders and even social revolutionaries have drawn power from false pride of masses (And unfortunately this power has been often abused.) Then it doesn’t come as a surprise that we are systematically trained since childhood to keep our ego blotted. And the trick used is - keep repeating something and soon people will start believing it.

Take for example the pride that people take in their religion. The truth remains that most of these people take pride in their religion because they just happen to be born in that religion. And their minds have been suitably poisoned by telling them repeatedly that their religion is great (and that other religions are somehow inferior). Now, it’s not bad to take pride in one’s religion if it one does objective study of various religions and finally selects the religion he finds to be “greatest”. Either that or maybe if one “achieves” one’s religion. If one has to clear a very tough test to get admitted to a religion then he should be reasonably taking pride. But in most of the cases neither of these is true. Most of the people rarely take time to study their own religion forget about studying other religion. Of course, nobody “achieves” his religion. It comes by default when one is born. If that is the case how come most of otherwise reasonable people are foolish enough to claim that their religion is “greatest” (Greatness defined vaguely enough to ensure that they need not actually study their religion and compare it with other religions before proclaiming greatness of one or another). The answer lies in systemic poisoning of people’s mind. We are born, given a religion and told “you are hindu / muslim And Hndu/ muslim is the greatest religion”. Of course it’s repeated so many times that we actually start believing it without any objective analysis.

Same reasoning goes for so many other things that we take pride in. I am born in India and I am told to believe that India is great.( what makes it great? its illiteracy ,poverty or corruption ?) Isn’t it true that India is one of so many countries and citizens of every county believe that their country is “great”. Story repeats itself in caste, skin colour and so many other divisions in humanity. The result is a divided and bleeding human race.

Let me clarify that I don’t have any problem with anyone taking pride in his or her religion (or country or caste or even indulging in honour killings). However, I am against human objectivity succumbing to rhetoric and spoon-feeding by vested interests.

I would like to believe that if children are taught to take pride in only what they achieve and not what they get by default, many of problems of our society could be solved. Then a man will not be proud of his father’s wealth or position but will take pride in only what he has achieved in life. He won’t be eager to go to war. He might actually realize that the country on the other side of border is equally great and he happens to be on this side by pure chance birth. Hopefully, as human civilization progresses, our minds will develop enough to take decisions based on objective analysis rather than what we have been fed by others. Maybe then we will study others religion before responding to jihad calls by fanatics. Am sure such a study will show that differences are too small to kill for. And of course another Hitler won’t be able to motivate one race to exterminate another race.

Nifty technical breakout; to target 5500

Indian stock markets are technically set for a bull run after major resistance was broken yesterday and confirmed today. I would remain long here with a sl below 5180 in nifty and 17290 in sensex. Expect nifty to target trendline resistance at 5450 and Sensex to target 18500 next. At target it will be advisable to wait for a break above it before initiating more long. Anyway the markets are still a long upside before long term target of sensex near 30000.