Trading ain't donuts

Imagine you open a little donut shot. You are a creative person. You experiment with funky flavors adding savoriness and spice to contrast against the sweet. People love them. You are busy from morning ‘till night and crowds build outside your doors from 6am every morning.

After a few months you start to think - Hey I could do this on the other side of town as well! So you go to the bank and take out a loan. Since you pretty much know you’ll sell 1,000 donuts each day you feel confident that you can meet the monthly nut on the loan and still make a positive spread on the whole operation. You do this over and over and over again until you’ve become the Krispy Kreme King of Kalamazoo running 25 stores all of them financed by the bank but all of them earning a positive spread making you profits every day..

This is the American dream, but try to copy it to the world of trading and will almost certainly turn into your worst nightmare.

Trading is unlike any other business in the world. Unless you are a market maker or an HFT fund the profit function in trading is never linear. If you have a trading system that is working well on the S&P and you think - Hey I’ll just lever up my account and will start  trading it on EURUSD and Oil and Gold and Nas - you will almost certainly run into the risk of ruin. That's because there is no homogeneity in trading like there is in the rest  of life. You can’t assume like you do with donuts that just because something works in one neighborhood it will work in another.

Now of course I am simplifying and exaggerating. Real life has plenty of heterogeneity. You’ll never get a Westerner to eat congee as their regular breakfast meal. But the heterogeneity in real life is much less pronounced than it is in trading. Otherwise sushi wouldn’t be the world’s most popular food from Dubai to Dubuque. In trading the variance is just much greater than in real life. The chance of tomorrow being pretty much like  yesterday is much lower in trading than it is in the donut business and we must all be vigilant not to fall victim to  “premature extrapolation” a term I heard the other day on @kevinmuir Market Huddle podcast that I absolutely love.

This is what makes trading so challenging and so maddening at the same time. The formulas are universal and you must always appreciate the fact that what worked yesterday may not work tomorrow.

One of the great traders of the 1980’s - Marty Schwartz, the author of PitBull - had a great rule that I think is worth following. Marty always preached that you were not allowed to increase size until you doubled the account. That could be a maddening slow constraint especially if you are trading well and are eager to open up more “donut stores” every day, but trust me that rule will save you from a lot of blown accounts because it embeds a natural discipline to your trading that requires a very high increase in  performance before allowing you to assume more risk.

Another idea that I find really useful for traders who trade systematically is to give each system a separate trading account. This has nothing to do with money management - after all you can trade multiple systems in one account if you size them properly. Rather this is a pure psychological hack that can also help you avert the risk of ruin because of one simple fact. If one system starts to go bad in your account you will always try to size up the other systems in order to make up the P/L. Trust me no matter how much you tell yourself you won’t do it you absolutely will if your trading capital isn’t physically segregated.

So yeah trading aint donuts. You can’t use the lessons of real life and apply them to the markets.  This isn’t a business where you can control the output of widgets by a few  simple turns of the knob on supply and demand function because supply and demand in trading are far more ephemeral than they are in real life. One moment the demand is there, the next it’s totally gone. Donuts are forever. Trading systems are not.