Dating, day-trading and the chance of choice!
There are many different flavours of the following problem. They all lead to an intriguingly simple answer and we will see how we may be able to access this concept in a trading environment. What I love about such generally frivolous mental excursions is their application to the more serious subject of finance (that is, if you consider, finance as a serious subject!). I would not bore the revered reader with the actual mathematical solution (you can write to me or google it if interested in that) but I would stick to the answer and the use of it in day-trading.
First the problem:
There is a known total population of potential candidates that you can date from. You can date one after another (this game is not for the Don Juans or for the lady versions of Don Juans, for, their penchant for prolific dating and seducing will not let them engage in a sequential dating process) till the end or you can choose to stop at someone you would want to spend the rest of your life with. If you come across anyone that suits you, you choose him/her and stop or you move on to the next but you cannot go back to dating a person who you dated before. Given these set of reasonable rules, how do you maximise the chances of finding that one person who will melt your heart? The optimality is important here because if you get married too early then you would regret for not having dated the better ones but if you wait too long then age will catch up and you will be left as a loner.
The answer:
It turns out that our approximate optimal strategy is to reject out of hand the first 37% (which is also equal to ‘1/e’) of the candidates and then select the first candidate (if he appears) that is better than all previous candidates dated. That is if you give yourself time to date 100 people then keep noting each person’s attribute (that you want as best for your compatibility) on a diary (or on your smart phone) and after the 37th person has been dated, start evaluating the remaining guys/gals and the moment you hit upon someone who is better than the best among the first 37, tie the knot with that one person. This 37 is a magic number on an average as the optimality.
Now where does this idea lead us to in trading? I choose day trading as a better form of all other trading because of one simple reason: Volatility of the book is proportional to the square root of the time period and hence lesser the time period one is exposed to the market, the lesser is the drawdown and volatility of the book. Also for retail traders and for traders who make a living out of trading there is an added emotional comfort in day-trading. It is as if every morning they start with the same Zen Koan: Every day is a good day! (The corollary to that is ‘every night is a good night’, not a night riddled with dreams of what will happen to the traded position if Mr. Putin bombs Turkey by mistake overnight or if Iran adds another 200 ships of oil to the already existing glut). Enough of singing paeans of day-trading and coming back to the matter on hand:
The way a trader could use this simple and effective number is to wait till 37% of the time (or number of bars) had elapsed and then choose the low or high of the market that is lower or higher than the lowest or the highest observed during the initial 37%. So for instance, if your trading is based on the half-hourly bars then wait for 6 bars to pass by and then from the 7th bar start noting if a new low or high gets printed. This new low or high has to be better than the low/high of the first 6 bars and once this is printed go long or short accordingly. Of the many types of ammunition available for a day-trader this one is predicated upon a sound logic of statistical decision making and the trader would do well to perhaps add another arrow to his quiver.
Originally published at https://www.linkedin.com.