Thesis - The first step of our TEST Trading Framework

What is a Thesis?

A thesis is the reason for our trade. This is the reason we enter (or exit) a trade.

A Thesis should be Falsifiable 

Something that is falsifiable can be proven wrong. This is a common term in science. 

We want our theses to be falsifiable so that we know if our reason for entering (or exiting) is right or wrong. 

If a reason for the trade cannot be proven wrong (i.e. not falsifiable), we wouldn’t know if it worked. 

And no, we can’t solely use the outcome of a trade to justify if it was the right decision. More on this later.

Example of a falsifiable thesis: 

China just banned their companies from buying Nvidia's chips. The news just came out on Chinese social media 5 minutes ago. NVDA stock has not moved yet.

You believe there is a high chance that NVDA will fall in the next hour.

You put on a short position.

Example of a non-falsifiable thesis: 

Drawing a triangle on a chart and betting that Bitcoin will fall based on that chart pattern. 

3 weeks after your triangle was drawn, Elon Musk made a tweet that caused Bitcoin to crash. So… did your triangle method work? Who knows?

More examples of falsifiable theses:

• Crypto assets are trading at different prices on different crypto exchanges. Buy it low on one exchange and sell it at a higher price on another.
• Predicting the outcome of Brexit using private polls.
• Placing a bet based on whether a country's President will approve or reject certain stock acquisition deals.
  
• 4 similar bond futures tend to trade at similar levels during normal market conditions. We long the futures that are cheaper and short[1] those that are more expensive.  

Litmus Test

The litmus test for a falsifiable thesis is that, when you explain it to a layman, their response is "I do agree with/don't agree with/have no view on your argument, but I can see how that makes sense."

Why Can’t We Use Short Term Trading Profits to Check If the Trade Was Correct?

Making profits doesn’t mean you made the right trade. Making losses doesn’t mean you made the wrong trade. 

Let’s illustrate with a dice game: 

If you roll 1, 2, 3, 4 or 5, you win $50. If you roll a 6, you lose $10. 

You chose to play this game. You rolled a 6 and lost $10. 

Does that mean you made a wrong choice? Of course not. That dice game is greatly skewed in your favour. You should take that bet. 

Similarly, short term trading profits and losses don’t determine if the reason for the trade was right or wrong.

This concept applies to almost all risk-taking endeavours like:

• Business decisions
• Poker
• Choosing a job
• Choosing a degree
• Choosing a life partner

Someone even wrote a book about it: Thinking in Bets

We can only make the best decision with the information we have. Whatever happens, happens.

P.S. 

On the contrary, long term exceptional performance does reflect the quality of a decision.

If a trader consistently makes profitable trades over decades. It is a statistical anomaly and you can conclude that on average, that trader makes good trades.

E.g. Warren Buffett.

Why is a Falsifiable Thesis Important? 

1) Proactive vs Reactive

Falsifiable theses allow us to be proactive not reactive. We know we are wrong before we lose money. In fact, sometimes, we know we are wrong when we win money. In the above falsifiable thesis example, if the story on China banning Nvidia chips is fake news, we know we are wrong immediately and close the trade. We don't need to lose money to know we are wrong.

In non-falsifiable theses, we don't even know if you are right or wrong after we lose or make money. Most traders who trade this way lose many times in a row before they start re-evaluating. It is a very expensive lesson if we lose 5 times in a row before changing strategies and we have dozens of (ineffective) strategies queued up - this leads to hundreds of losing trades with no improvement.

2) Dead Trading Psychology and Pretend-Trading

If we trade non-falsifiable theses, our trading psychology will go downhill as we are constantly in emotions of FOMO, regret, and self-doubt.

We'll never get a perfect trade. If we win, we struggle with how we could have won more. If we lose, we struggle with how we should have avoided this trade.

We think we are reflecting and making improvements but we are just play-pretending. This will lead us nowhere.

Imagine a lottery bettor analysing his lottery bets and thinking that he should improve by buying only even numbers and on Thursday mornings.

That is what trading with non-falsifiable thesis looks like.

3) No Process and Improvement

You'll learn more about the TEST framework later. In short, once we have our falsifiable thesis, we can conduct steps 2, 3 and 4 of the TEST Trading Framework: 

Step 2: Expected Value – We use the thesis to calculate what is the expected outcome of the trade 

Step 3: Sizing – We use the thesis to calculate how much to bet 

Step 4: Trade Management – We use the thesis to tell us if we are still on track, and whether we should be more aggressive or cut our losses. 

Everything stems from our falsifiable thesis. 

Without a falsifiable thesis, there is no trade. There is no process. There is no improvement.

We are not making correct decisions and are not improving. We are flying blind based on gut feel. i.e. we are gambling.

4) Bankruptcy

Most new traders, including myself, start with these non-falsifiable theses. This is normal and to be expected.

They either lose all their money and give up, or (a very small minority) learn about falsifiable theses and start making small improvements to their skill.

They might not call it "falsifiable theses", but it's the same idea. 

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[1] https://www.investopedia.com/terms/s/shortselling.asp

Instructor: Lucas Liew