What is a Thesis and Why should it be Falsifiable
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.
A falsifiable thesis is based on logic and can be proven wrong using logical deduction.
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:
Betting that Tesla will fall because you believe they will miss their earnings expectations and guide for lower revenue.
This can be falsified because Tesla’s earnings announcement and the stock movement immediately after the announcement will prove if you were right or wrong.
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.
- 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.
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?
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 thesis.
Without a falsifiable thesis, we are flying blind based on gut feel. i.e. we are gambling.
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[1] https://www.investopedia.com/terms/s/shortselling.asp