The Laws of Trading

1. Know Thyself: Understand Your Trading Motivations

Know why you are doing a trade before you trade.

Motivation matters. Understanding your motivations for trading is crucial because it directly impacts your decision-making process. Are you trading to make money, to seek intellectual validation, to alleviate boredom, or to satisfy a risk-seeking appetite? Recognizing these underlying drivers helps you avoid emotional traps and make more rational choices.

Irrationality abounds. Human beings are not perfectly rational profit maximizers. Cognitive biases, such as overconfidence, hindsight bias, and the Dunning-Kruger effect, can cloud judgment and lead to poor trading decisions. Being aware of these biases is the first step in mitigating their influence.

Self-awareness is key. By understanding your motivations, you can better protect yourself from being exploited by others who may be aware of your weaknesses. This self-knowledge allows you to structure your trading approach to minimize the impact of non-profit-driven desires, leading to more consistent and profitable outcomes.

2. Adverse Selection is Inevitable: Embrace Discomfort

You're never happy with the amount you traded.

Information asymmetry. Adverse selection arises from information asymmetry, where one party in a transaction has more knowledge than the other. This is a fundamental aspect of trading, leading to the realization that you'll never be completely satisfied with the outcome of a trade.

Relative knowledge matters. Your absolute level of knowledge is less important than your knowledge relative to your counterparty. The goal is to be better informed than the person on the other side of the trade, allowing you to make more advantageous decisions.

Bayesian updating. Markets are constantly evolving as new information becomes available. Successful traders must continuously update their beliefs based on market signals, such as price movements and the actions of other participants. This iterative process of belief-updating is essential for navigating the complexities of trading.

3. Risk Management is Paramount: Hedge or Be Humbled

Take only the risks you're being paid to take. Hedge the others.

Define your capital. Capital is the lifeblood of trading, and understanding its true value is essential. It's not just about the money in your account, but also the opportunity cost of using that capital for one trade versus another.

Hedging reduces exposure. Hedging involves taking offsetting positions to reduce or eliminate unwanted risks. By hedging out risks you're not being paid to take, you can focus on the specific risk factors where you have an edge, increasing your chances of profitability.

Risk comes in many forms. Market risk is the most obvious, but counterparty risk, liquidity risk, model risk, operational risk, technological risk, and reputational risk all play a role. A comprehensive risk management strategy addresses all of these potential pitfalls.

4. Liquidity is King: Prioritize Tradability

Put on a risk using the most liquid instrument for that risk.

Liquidity defined. Liquidity refers to the ease and speed with which an asset can be bought or sold without significantly affecting its price. High liquidity is crucial for minimizing transaction costs and managing risk effectively.

Liquidity is relative. The perceived liquidity of a market depends on the size of your trade, the frequency with which you trade, and your level of sophistication. What may be liquid for a retail investor may be illiquid for a large fund.

Liquidity affects strategy. Always consider the liquidity implications of your trading strategy. Illiquid positions can be difficult to exit, especially during times of market stress, potentially leading to significant losses.

5. Edge is a Story: Tell it Simply and Defensibly

If you can't explain your edge in five minutes, you don't have a very good one.

Edge defined. Edge is the reason why a trade makes money, the unique insight or advantage you possess that allows you to profit consistently. It's the story you tell yourself to justify taking a particular risk.

Simplicity is key. A good edge should be easily explainable. Complex, convoluted explanations are often a sign of overthinking or a lack of true understanding.

Combat biases. Be aware of cognitive biases, such as overconfidence and confirmation bias, that can cloud your judgment and lead to false perceptions of edge. Seek out dissenting opinions and challenge your own assumptions.

6. Models Express Edges: Simplify, Test, and Adapt

The model expresses the edge.

Models simplify complexity. Models are useful simplifications of the real world, allowing you to make predictions and informed decisions. However, all models are inherently flawed and should be treated with caution.

Generative vs. phenomenological. Generative models attempt to capture the underlying mechanisms driving market behavior, while phenomenological models focus on describing observed patterns. Both types have their strengths and weaknesses.

Test and validate. Rigorously test your models using historical data and out-of-sample validation techniques. Be wary of overfitting, where a model performs well on past data but fails to generalize to new situations.

7. Costs Erode Edge: Scrutinize Every Expense

If you think your costs are negligible relative to your edge, you're wrong about at least one of them.

Costs are multifaceted. Trading costs extend beyond brokerage fees and commissions. They include market impact, opportunity costs, and the often-overlooked cost of trade depreciation.

Trade depreciation. The very act of trading profitably can erode the profitability of the trade over time, as others copy your strategy and compete away your edge. This is an invisible linear cost that must be accounted for.

Minimize and monitor. Scrutinize every expense and actively seek ways to minimize costs. Regularly monitor your trading performance to identify any signs of cost creep or trade depreciation.

8. Markets Evolve: Adapt or Perish

If you're not getting better, you're getting worse.

Markets are dynamic. Financial markets are constantly evolving, driven by technological advancements, regulatory changes, and the actions of other participants. A trading strategy that works today may not work tomorrow.

Adaptability is essential. Successful traders must be adaptable and willing to continuously learn and evolve their strategies. This requires a commitment to ongoing research, experimentation, and a willingness to abandon outdated approaches.

Embrace change. View market changes as opportunities for innovation and growth. By staying ahead of the curve, you can identify new edges and maintain a competitive advantage.

9. Incentives Matter: Align Interests for Success

Working to align everyone's interests is time well spent.

Agency problems. Misaligned incentives can lead to suboptimal outcomes. It's crucial to structure your trading operation to ensure that the interests of all participants are aligned.

Incentive structures. Consider the incentives of brokers, lenders, and other counterparties. Design your trading strategies to minimize conflicts of interest and maximize mutual benefit.

Culture of alignment. Foster a culture of transparency, collaboration, and shared success. This can help to mitigate agency problems and promote a more cohesive and productive work environment.

10. Technology is a Double-Edged Sword: Master it or Be Overwhelmed

If you don't master technology and data, you're losing to someone who does.

Data is power. In today's markets, data is a crucial resource. Successful traders must be proficient in data analysis, statistical modeling, and other quantitative techniques.

Technology is essential. Modern trading relies heavily on technology, from high-speed trading systems to sophisticated risk management tools. Mastering these technologies is essential for staying competitive.

Human oversight is crucial. While technology can automate many tasks, human oversight is still necessary to manage risk, adapt to changing market conditions, and identify new opportunities.

11. Humility is Essential: Embrace Continuous Learning

Just because something has never happened doesn't mean it can't.

Markets defy prediction. Financial markets are complex systems with inherent randomness. Avoid hubris and recognize the limits of your knowledge and abilities.

Embrace uncertainty. Be prepared for the unexpected and develop strategies for managing unforeseen events. Acknowledge that even the best models can fail.

Continuous learning. Commit to a lifelong pursuit of knowledge and understanding. Stay curious, challenge your assumptions, and never stop learning from your mistakes.

Last updated: February 22, 2025