The Dangers of Sage Advice

The Dangers of Sage Advice

June 7, 2017

Trading isn’t easy.

It’s not easy to find a trading system that works.

It’s really not easy to find a trading system that works and makes the right amount of money.

Once you do find a system, it’s not easy to trade it properly or learn how to make robots trade it properly.

Once you trade it properly, unfortunately it is easy to use a trade size that’s too big and bankrupt the account.

And most of all, it’s not easy to trade anything when you lose. Giving up and going back to making money the “old fashioned way” is a lot easier than fighting through a losing streak.

Because trading isn’t easy, any little bit of advice helps.

Any little nugget that may save time or save pain or save money is greatly appreciated. It can really make a difference.

On the other hand…

It seems like a lot of people like to throw out crusty platitudes and disguise these platitudes in the form of “trading truisms.” I think they think they’re helping. I hope they think they’re helping.

They’re not helping.

In this month’s Modern Trader magazine, there’s an article by a well-known trading veteran (literally decades in the business) who is trying to help us spot scams. That seems like a good thing.

In the article, the famous trading veteran goes into detail into how to spot a faulty backtest and how charlatans rig backtests, optimizing their systems “to sell, not earn.”

Again, helpful.

When we get to his first litmus test, though, he says:

“…legitimate system rules are the same for longs and shorts. Never trust a performance summary that looks better because of dissimilar long/short mandates…”


Why yikes?

Because this is a very, very dangerous statement. It’s dangerous because:

  1. What if he’s wrong? If there are successful systems out there that have different rules for long and short trades, then we’re left with no other alternative than to say he’s flat-out wrong. If he’s flat-out wrong, then how does telling us untruths help us? As a result, the rest of his article becomes suspect and we’re left with indecision and confusion all around.
  2. How much money could we possibly miss out on because we took his advice and threw out all systems that don’t have identical long and short rules? Ignoring profitable systems based on bad advice could cost us lots of money.

So this becomes a very important question: Is he telling the truth?

The easiest way to look into this is to see if we can find any famous people that have a trading record that proves him wrong.

First, we could go right to the top. How about Warren Buffett? We know about what he’s achieved by buying and holding stocks for decades. So let’s take a look.

Roughly speaking, Buffett’s trading rules for longs are: 1) Do your research; 2) Buy stock in a company with a competitive edge at fifty cents on the dollar (or better). Fine.

But what are his rules for short trades? What are all of the great short trades he’s taken and is currently still holding on to?

If you answered I don’t know and I don’t know, I believe you’d be correct. It’s understood that Warren Buffett doesn’t short stocks. This is a crucial point.

If Buffett doesn’t short stocks, then his rules are different for longs and shorts! Buy at fifty cents on the dollar for longs, do not take shorts. Those are different rules!

And if Buffett has shorted stocks, clearly it’s with different trading rules. He’s not still holding shorts from 1987 like he is with Coke. He didn’t short a bunch of stocks at 50% over fair value and hold them forever.

Which means, of course, that the most famous, most wealthy investor of all time has different rules for longs and shorts.

Let’s try another one.

How about William O’Neil? He created Investors Business Daily and his disciples still hold seminars all over the world. His books show pages and pages of all of the best stock winners of all time. Do you know something interesting about all of the greatest winners of all time? They’re all long trades. He doesn’t like shorting stocks (even though he wrote a book about it).

He doesn’t like shorting stocks because the short side of the market is more difficult. You can’t use the same rules for shorts, according to him, because the short side of the market is different. In other words, you have to use different rules to short stocks! One example: O’Neil recommends a completely different stoploss level on shorts.

So there’s another example of a famous person who uses different rules for longs and shorts.

Do you want one more? How about the stock system we talked about last week? This system, designed by Joel Greenblatt, has a “Magic Formula” for buying value stocks and holding them for one year and one day.

However, the Magic Formula filter/scan is for long trades only. No shorts. So his rules are to buy good stocks on sale and do nothing for shorts. That, again, is a successful system with different rules for longs and shorts.

I’ve been testing robots obsessively since 2012 and one of the most important lessons I’ve learned is this: the long side of the market and the short side of the market are not the same. As a result, it would be wise to consider having different rules for longs and shorts. It’s not mandatory, but I recommend it.

If I had come across this article from this trading veteran at the beginning of my trading career and believed him, it could have cost me dearly.

The bottom line? Listen to trading truisms, but test them for yourself.

Sometimes the help we think we’re getting might not be any help at all.