How College prepared me for Trading

In earlier articles on my trading journey, I commented on how lessons from trading world could be applied to the corporate world. This article takes a different approach. I discover how my college, or to be precise my studying statistics, prepared me for the trading profession.

Let me recap the last week for those who do not track the stock markets of India. On Friday, the 17th of September 2021, the market opens at an all time high but ended the day lower by 44 points or 0.25% down. The following Monday, the 20th of September 2021, it opens gap down by 142 points. Soon the news channels started reporting how this was one of the biggest gaps for the index.

I have joined a few circles of new traders like myself who are learning. There are a few experienced traders in the group. We usually identify some approach and do some research which is published in the various groups. But this is just a handful of the members. The others are simply there to take our inputs and start trading.

When the markets started going in red on 20th September, all hell broke lose in all the groups. The news pandits started talking of how this is the start of the great collapse. Everyone in the group started talking of selling. People were posting how their portfolio has lost from 1 to 3 % in the two days. They wanted to take their money out and cut their losses. This was one of the days when most of the experienced traders were absent from the groups.

In all the mayhem, I realized that I was very calm. Yes! I did see my portfolio also drop by similar percentage. But, in my mind, I was in a state of acceptance. When I look back at the week, I realize that what differentiated between the calm traders and the shouting Thomas’ was that the former were heavy into back testing.

Back testing is where a trader takes a strategy, defines the rules, goes back in time and checks how the strategy would have performed in the past. In this article, I will disclose my approach. I back test over every stock comprising the Nifty index (which is 50 in number) for the past 10 years i.e. I go day by day and test the strategy for each day. I note my buy, sell, profit, gains, notional losses on a down day, etc. At the end of the exercise, I know if the strategy makes profits, on which stocks, how much profit, how much capital is required, and most important how much reduction or drawdown in portfolio. This is followed by forward testing on paper and then forward testing with limited actual trade. After this activity, if the strategy shows a positive expectation, then I put it into trading with real capital allocated to it.

?What happened on 17th and 20th September was well within my range of portfolio drawdown. So, I was not perturbed by the drop in market. Most of the traders in the group sold out to cap their losses or took a drop in their targets. The experienced traders just stepped away from the market and did not do any trade. Some may even have added to their positions.

A key activity of statistics is hypothesis testing and model building. I spent 3 years studying statistics for my graduation. Without going into details, our exams included a 3 hour paper where we were given number series, sometimes about 200, and an assumption. We were to test this assumption using the statistical models. We were only allowed a calculator. We divided the number series into two sets – a train and test set. We identified the appropriate model based on the problem definition and then applied it over the train number series manually to check how good the fitment was. Then, we applied it to the test set to check if we get the same results. To prepare for the exams, we used to spend those few hours everyday practicing different problems.

Doing this exercise for the large number of times almost daily for three years, somehow inculcated the habit to look into the past and test our assumption before projecting into the future.

This is akin to the back testing in trading systems. In all the trading training courses I attended; the instructors used to emphasize on manually testing each strategy over the past. One of the instructors had a phrase – “back test over a hundred charts every day”. Almost all instructors said that they know 90% of the students will not do the exercise. These 90% will fail and the other 10% will only be the successful traders. I was always comfortable with doing the back testing. In fact, in the last training I attended, I actually stopped all my trading activities for 2 months so I could back test a strategy over 150 stocks for past 10 years.

In the trading circles, every time a new trader or anyone asked questions like does this work?, how much return to expect?, when to take profit?, how much capital?, etc.; I always replied them to do back test and find out. In one of the group, there is joke going around that the only answer I give is “back test, back test, back test”. But most of them just wanted someone to give them a readymade answer. These were the same people who panicked last week and many of them sold out.

To conclude the article, today is the 26th of September 2021, the market is at a new all time high and over 400 points higher than its closing on 20th of September 2021.

I have one more reason to be glad I opted to graduate in Statistics. I got trained in a mindset that I am confident will help me in my trading learning journey.

*I am using Nifty 50 Index for my example.