If you read our article about expected value and what separates the top 1% of traders from everyone else, you know that profitable traders think in terms of expected value and have extreme price sensitivity when they look at the markets. But how do they actually have the confidence to put their money behind these ideas? This isn’t something you just feel out; you can’t just feel like something’s cheap or expensive. You need to put numbers behind your ideas to determine if they make sense and if you should put your money behind them.
Key Takeaways
- Evidence-Driven Approach:
- Profitable traders rely on statistical analysis and backtesting to validate their strategies. They don’t depend on gut feelings or anecdotal success stories but instead use solid data to guide their decisions.
- Critical Evaluation:
- Always question the rationale behind any strategy. Seek logical explanations and supporting data to ensure it has a positive expected value, before you put your money behind an idea.
Evidence-Driven vs. Faith-Driven Trading
One of the biggest differences between successful traders and everyone else is that successful traders are evidence-driven, while others are faith-driven. Let’s break this down.
What does it mean to be faith-driven?
The average person relies on technical analysis and chart patterns, investing money based on these signals. They see a breakout and invest, hoping to profit if the stock continues to rally.
But why should a breakout indicate future profits? Is it because someone told us it works, or we read it in a book? Maybe we’ve seen those patterns work and profited from them ourselves. However, these are anecdotal pieces of evidence, not solid proof.
Faith-driven trading is putting trust in these ideas without solid evidence. On a trade-by-trade basis, it’s hard to evaluate their effectiveness. Just like a gambler can win several hands in a row at Roulette, a trader might profit from a few trades based on these patterns. But it’s over a large number of trades that the true effectiveness becomes apparent.
The Importance of Being Evidence-Driven
Successful traders, like casinos, are evidence-driven. Casinos don’t just think a game will make them money; they know it will. They understand the odds and expected outcomes before the game even hits the floor. Similarly, successful traders put evidence behind their strategies, giving them conviction that they will make money.
The Casino Analogy
To understand this better, consider how casinos operate. Before introducing any game, a casino meticulously calculates the odds and ensures the game will be profitable in the long run. They use statistical analysis and game theory to forecast the outcomes. This evidence-based approach guarantees that, over a large number of plays, the casino will always come out ahead.
Similarly, traders who succeed in the long term use data and statistical analysis to back their trades. They don’t rely on gut feelings or anecdotal success stories. Instead, they rigorously test their strategies, using backtesting and historical data to validate their ideas. This scientific approach to trading removes the guesswork and replaces it with confidence and reliability.
Practical Steps to Become Evidence-Driven
Backtesting Your Strategies
Backtesting involves running your trading strategy through historical data to see how it would have performed in the past. It quite literally aims to answer the question “Does doing this action actually make money?”. Backtesting helps identify patterns and outcomes that are statistically significant. By analyzing past performance, you can estimate the potential future success of your strategy. This evidence provides the confidence needed to put real money behind your trades.
Keeping a Trading Journal
Think of this as the other side of the coin from backtesting. A trade journal is keeping a log of the real trades that you place. Document every trade you make, including the rationale behind it, the expected outcome, and the actual result. Over time, this journal becomes a valuable resource, allowing you to analyze what works and what doesn’t. You can compare the statistics based on the trades from your trade journal against the trades that were simulated in the backtest. If the strategy is working as it is intended, you should see imsilar risk profiles, returns, etc between the trade journal and your backtest. This ongoing analysis helps refine your strategies and ensures they continue to operate as they should.
Leveraging Technology
The more steps that we can automate and offload to technology the better. This is of course assuming that there is no loss in the effectiveness. Need to scan for trades that meet a certain criteria? Use a tool. Need to fight for fills in an extremely illiquid market? Maybe handle that one manually.
Shifting from Faith-Driven to Evidence-Driven
Transitioning from a faith-driven trader to an evidence-driven one is straightforward, at least psychologically. Just be critical of everything you hear, even what you learn in this course. I’m not suggesting that you become a tin-foil-hat-level conspiracy theorist. I am simply suggesting that a healthy dose of skepticism is good for traders. In the end of the day, gullibility bankrupts.
Always ask:
- Why does this make sense?
- Why should this make money?
- Does it have a logical explanation?
- Is there data to support this idea?
By consistently questioning and seeking evidence, you ensure that you are not just following patterns blindly. This critical approach helps you develop strategies with a positive expected value, aligning you with the 1% of traders who are truly profitable.
Joining a Trading Community
Honestly it’s going to be pretty difficult to fully switch the way you think about trading if you are stuck in an echo chamber of faith driven traders. So whether it is by becoming a part of our exclusive network of traders (which is awesome by the way) or by branching off and finding some other way to get in touch with serious traders, it is absolutely imperative that you find like minded traders to collaborate with.
Conclusion
Being evidence-driven rather than faith-driven is a fundamental shift that can dramatically improve your trading success. By rigorously analyzing and validating your trading ideas, you build a foundation of confidence and reliability in your strategies. This evidence-based approach, combined with a focus on expected value and price sensitivity, is what separates the top 1% of profitable traders from the rest.
