Thursday, April 22, 2010

Decision Trees

At some point during a trader's learning curve they will undoubtedly be introduced to the idea of developing a trading plan. Achieving consistent results necessitates having a consistent approach. It is quite unrealistic to expect consistent returns month to month if you lack structure in your approach. While shooting from the hip or "winging it" may require less effort, it is usually a recipe for disaster in the long run. Each trader should have some type of method to the madness, a rhyme and reason as to their timing, trade, and risk management. A systematic approach has helped me in producing more consistent results.

While there are numerous ways to explain one's trading plan and outline the decision making process, one tool of worth I've found particularly useful with adjustment trading is a decision tree, such as the one displayed below:

Decision trees offer the ability to model potential trade adjustments based on changes in the underlying market. In the tree highlighted above I've displayed the Sling Shot trade mentioned in Tuesday's post with various adjustments worth considering. T1 represents the original trade, while T2 and T3 represent secondary and tertiary adjustments. The beauty of the decision tree lies in its flexibility, as it allows users the ability to create very simple or largely complex models.

I've also found them quite useful from an educational standpoint. It's proved much simpler to show the potential adjustments traders may make at various points in a trade as opposed to explaining them.