This tutorial and the articles below discuss the importance of psychology in the trading and investing process. While you cannot control the market; you can control your money and the risk that you put on every trade and your attitude to trading. A definition of successful money management is to maximise every winning trade and minimise loss. In other words, the idea is to lose the least amount of money when you are wrong. The difference between a winning trader and a losing trader has a lot less to do with the winning trader's knack of picking winners. All winning traders know to expect losers and to expect lots of them. A consistently successful trader understands that on any given trade, on some level, chance is involved. Losing some trades is inevitable; but successful traders acknowledge this. While it is nice to be making money when the market moves in your favour; it is the times when it does not that are more important with regards your market psychology.
You do not always need to be right
A common belief among novice traders is that one always needs to be right. Many believe that a trading strategy must always produce a profit. Although it is true that a long losing streak can wipe out one's trading account, one can actually have a large proportion of losing trades to winning trades and still be profitable. It is merely a matter of using risk management. Let us consider a specific hypothetical example to illustrate this point.
Suppose John has R150 000 to invest. He decides to arbitrarily risk 5% of his capital on each of 10 trades. He figures it is a relatively small amount that he could afford to risk and lose. He also decides to use a simple stop-loss rule: if a share price drops below 8% of the purchase price, then sell. He then uses an arbitrary sell rule for his winning trades: If a share increases by 20% of the purchase price, then sell. (Please note that we are not advocating the use of these rules, we are just trying to make a point).Let us calculate the expected results. Approximately R7 500 is risked on each trade. If the trade loses R600, it is sold. If the trade produces a R1 500 profit, it is sold. If 3 out of 10 trades are winners, the overall profit (wins - losses) is (3 X R1 500) - (7 X R600) = R4 500 - 4200 = R300. Now, R300 is not very much of an overall return, but you can see the point. Even by winning only 3 out of 10 trades, there is still a profit.
This is quite a conservative strategy. One probably would not want to follow it precisely. It demonstrates, however, that one does not always need to be right all the time to come out ahead. Nevertheless, you may see that a few modifications can make the general approach very profitable. For example, if one were to win 50% of the trades, the expected profit is (5 X R1 500) (5 X R600) = R7 500 - R3 000 = R4 500. Similarly, one probably would not want to sell a winning trade merely because it reached a 20% profit. One can "let it ride a little longer" and perhaps make a 50% profit, for example. This would result in even more overall profits. The incorporation of risk management rules allows you to be wrong a lot of the time, and it is reassuring to remember this point.
So remember that you do not always have to be right to make a profit overall. Even by using a very simple set of risk management rules, and following them mechanically, you can come out ahead. The lesson here is not to use such rules mechanically, but to consider how some simple planning and risk management can prevent emotions, such as anxiety and fear, from negatively impacting your trading decisions. When you are first learning to trade, risk management can help you survive, stay in the game, and allow you to hone your trading skills. As you gain more skills, you can risk a little bit more on trades you have identified as "high probability setups" and fine-tune your stop-loss or exit rules. But in the meantime, consider keeping your goals modest, with the main goal of minimising risks, building skills, raising self-confidence, and refining your method.
It is not my fault - why it is so hard to take responsibility
A fundamental truth of trading is that one must take full and complete responsibility for both failures and successes. It is easy to take credit for a winning trade, but a losing trade? Our first instinct is to find an excuse: "The market conditions changed too quickly. The market makers are manipulating the price again. I should not have taken the advice offered by that uninformed analyst." It is easy to find excuses for losing trades, but in the end, a winning trader takes full responsibility for all aspects of a trade, what went right and what went wrong. Taking full responsibility is crucial. Traders who do not take full responsibility will devote the bulk of their psychological energy to defending themselves against their mistakes. Rather than cultivating a pristine view of the markets, they will tend to hold a view distorted by their burning desire to avoid blame. In addition, while one is finding an excuse for an adverse event, no time and energy is devoted to anticipating adverse events and thinking of preventative strategies to neutralise them. Unfortunately, for many traders it is difficult to take full and complete responsibility.
Why is it so hard to take full responsibility? A variety of psychological explanations exist, and they differ depending on the person and his or her psychological history. Everyone tends to avoid responsibility to some extent. There is a very human tendency to build up our egos and feel good about ourselves. In explaining the outcomes of our lives, we often attribute success to our skill, intelligence, and talent, and attribute failure to external circumstances, over which we had no control. This general tendency usually helps us cope with most of the adverse events we encounter in our everyday lives, but this tendency is self-serving and impedes one from taking preventative measures to anticipate potential adverse events.
For some people, making excuses and avoiding responsibility is rooted in early childhood. Some people grew up with parents who spent all their effort pointing out and severely punishing every single mistake their children made. As children, they learned that to avoid punishment, they had to make an excuse and place the blame for the mistake on anyone but themselves. The consequences of making even the most minor mistake were so dreadful that they felt a strong need to avoid responsibility at all costs. Perhaps most people experienced this type of parent-child transaction to some extent, but at an extreme, it can incapacitate. One becomes afraid to act out of a fear of failure. And when a trader fears failure, he or she will be unable to try out new trading ideas or will be afraid to accept full responsibility for the trade.
Taking full responsibility for losses is difficult. One has to be confident enough to realise that just because one makes a mistake, or misses a potential adverse event, it does not mean that one is inadequate or incompetent. It merely reflects the way things work. No one is perfect, and mistakes are certain to happen. But avoiding responsibility is even a bigger mistake. Placing the blame on someone else or external events makes one less cautious. All psychological energy is focused on defending oneself, but all energy should be spent calmly identifying potential adverse events and finding creative solutions to counteract them. Taking full responsibility ensures that these preventative steps are taken.
The influence of sunk costs
Simon has been following Altech shares for the past two years. It is his most favourite share in his portfolio. He likes the company. He anticipates new product announcements with excitement and cannot wait to see consumer reaction. He has read several research articles on the history of the company, and he admires the CEO. Simon has most of his trading capital in Altech shares. Although he has a strong passion for the company, you might say that Simon is a little over-attached or married to the company. He may have too much of his personal emotions wrapped up in the company, and it is possible that these emotional attachments may overly influence his trading decisions. He has not only invested a lot of his money in the company, but a lot of his personal time and effort. These financial and personal costs may lower his objectivity. When it comes to making
decisions about trading the share, it is quite possible that he may be unduly influenced by what scholars call the "sunk cost effect." It is useful to be aware of this bias, and make sure that it does not subconsciously influence your trading decisions.
The clearest examples of sunk cost effects are when we overpay for something, whether it is with money, effort, or time. The more you pay for something, the more you value it. For example, if you spend a year's salary on a new car, you believe it is worth what you paid for it. So when you try to trade it in a year later, and the trade-in value is a lot less than you think it should be, you feel a little upset. You may defiantly think, "How could it be worth less than what I owe? I think I am getting ripped off." You feel "cognitive dissonance." That is, there is a logical inconsistency, or conflict, that requires resolution. You paid a lot for the car, but now its value is less than you had thought. To resolve the uneasiness of the inconsistency, something in your psyche must change. You may think, "I will keep the car longer and get more value out of it." But, even if you decide to trade it in, it is hard to just write off the amount lost to depreciation. Humans have a natural aversion to loss of any kind, and that is especially true when it comes to the market.
People tend to believe that an investment is worth what they paid for it. They believe that the original purchase price endures, even when current market prices suggest that the value has decreased. Sunk costs tend to increase when the value of the share decreases. It is hard to write off a loss, so when the value decreases substantially, it causes cognitive dissonance. You think, "I paid R50 a share. I thought it would at least go up to R55, but now it is down by 40%." That is logically inconsistent, so the easiest course of action is to believe, "I do not care what the current price is. It is worth at least R50, so I am going to wait for the price to recover." Such a belief returns logical consistency to your psyche. That is the easy thing to do but not the most prudent. A losing trade rarely turns around, and all the hoping in the world is not going to make the share price go back to the entry level. One has to do the hard thing: Admit that you were wrong, write off the loss, and close out the position. It is hard to do. When sunk costs are high, some traders may take on a fatalistic outlook. They may believe that since they have lost a large amount of money anyway, they have very little to lose by waiting to see what happens next. It is like thinking, "I have lost so much already that I cannot lose much more." Although such thinking makes one feel better about a losing trade, it is dangerous psychologically. One could lose the entire investment and experience excessive stress unnecessarily. There are real financial and psychological costs for refusing to ignore sunk costs. It is better to evaluate the potential of a trade based on what you can realistically make in the future and assume that you will not be able to recoup what you have lost. If you cannot see how the trade can turn itself around, cut your losses. By doing so, you will reduce your psychological and financial costs in the long run. It is useful to be aware of the ways the sunk cost effect may influence your trading decisions. Do not let it get the best of you. Now that you are aware of it, you can identify this decision making bias. Do not be afraid to cut your losses and move on.
Putting up a strong defence
When the defensive linemen go out onto the playing field to play American football, they make sure that they have helmets, facemasks, shoulder pads and other protection. The opposition is often formidable and there is no reason to unnecessarily risk getting hurt. When it comes to trading, it is also vital to have proper protection. Adverse forces may go against your trading plan, and unless you protect yourself, you run the risk of getting hurt, and with trading, that often means substantial hits to your trading account balance.
There is also a psychological advantage to going out onto the playing field with the proper protection. Taking the American football analogy one step further, consider the quarterback who does not have a wall of team mates on the line defending him. If they cannot hold back the opposition, he has to make a play under pressure. He may feel the need to throw the pass too soon to avoid getting sacked. Acting under pressure often leads to an error, such as throwing an interception or dropping the ball. Proper protection, in contrast, not only protects the quarterback from possible injury, but it gives him the time and opportunity to think more clearly, make a calm, thorough survey of all possibilities, and throw the ball to the player who has the best chance of making it to the goal line. It is also true with trading. If you have money on the line that you are afraid to lose, you may feel like the quarterback who is afraid of getting sacked. It is hard to stay relaxed and focused. One feels the pressure to act quickly so as to avoid harm. This often results in impulsive decisions, and over the long haul, a significant loss of capital. Risk management provides not only protection from financial loss, but also gives the trader a psychological advantage.
Just as when playing sports, there is an optimal level of energy that a trader should try to maintain. A tired and listless player cannot even play the game, but on the other hand, too much energy is detrimental. When one is under too much pressure and totally stressed out, he or she cannot think clearly. This is due to the fight-or-flight response. The body responds to threat by focusing all energy on impulsive reactions to neutralise the threat. When the stress is on, there is a natural human tendency to narrow one's focus, and react spontaneously. Such impulsive reactions usually fail to produce a desirable outcome. It is just like the quarterback who accidentally throws the ball into the hands of the opponent because he felt enormous pressure to act. For the trader, proper risk management allows the trader to control stress and trade at the optimal energy level.
There are many ways to manage risk. But one of the best ways is to develop a very detailed trading plan in which you estimate the potential risk up front. For example, you may estimate how far the trade may move against you. When going long on a swing trade, you may reason that the most the share price will go against you is the low of the previous week. That will give you an estimate of risk up front. Many trading experts also suggest making sure that the amount of risk you take on is only a small percentage of your trading capital, so that should you lose on the trade, the loss will be at a minimum. Whatever approach you take to managing risk, the point is that managing risk has both financial and psychological advantages. Psychologically, you will feel a sense of security. Deep down, you will know that should you lose on the trade, it cannot hurt you very much. It is only a small part of your capital, and you know you will survive to move on to new opportunities. You will feel more relaxed. And when you feel calm, your mind will be open to all possibilities. You can gauge the market action more objectively than when under pressure. In all likelihood, your mind will move with the market, and you will be able to trade effortlessly, and reach a peak performance state.
Putting the trade in the right perspective
As a novice trader, John has just put on his tenth trade. He is still new to trading, but he is optimistic that he will be successful. He wants to succeed. He thinks, "I want to prove that I am a good trader. I hope I do well on this trade. The outcome is critical to the rest of my trading career." John's thoughts and feelings are understandable. Whenever we start a major endeavour such as starting university, a new job, or whatever, we want to succeed. And it is nice to have early success. The first few moments of a major life turning point seem especially significant. When we are not successful immediately, the initial let down often haunts us for a long time, interrupting our train of thought, and shaking our self-confidence. Despite the reasonable hope of an early triumph, however, it is vital to keep the proper perspective when approaching trading: one must always think of the big picture, the long run.
Any single trade is of little importance. Experienced traders know this fact, and live by it as if it were doctrine. Even though they may focus all their energy on the current trade, they know it is of little real significance in the long run. You should also put each trade in proper perspective. It is essential that you consider, at least in the back of your mind, that a single trade is just one among a series of trades, and that the bottom line is the overall outcome across the series, not any single outcome. There are psychological advantages to taking this perspective. When you downplay the outcome of any single trade, it is less critical to your ego. When viewed as just one in a long line of trades, it is easier to tell yourself, "It does not matter. There will be many more trades and opportunities to come." If there is not much riding on the outcome of a trade, it will free up precious psychological energy. You would not waste your limited psychological resources needlessly worrying about the outcome. You will feel free and creative, ready for whatever happens next. All your attention will be focused on trading your plan, objectively analysing how market moves fit into your plan, and taking decisive action for a clean exit.
Putting a trade in proper perspective is not only psychological, however; it also involves proper risk management. To survive the learning curve, or a severe drawdown, you must limit your risk on any single trade. By limiting your stake to a small percentage of your trading capital, the trade will have minimal financial significance. In reality, it will be of little consequence compared to your overall account balance. Merely believing that a trade is insignificant does not work very well unless in reality it is not significant. For example, it is hard to fool yourself into thinking that a trade is insignificant if you have a month's salary on the line on a single trade, and you cannot afford to lose it. The stress will be unbearable. It is important for your psychological and financial security that you limit the risk on any single trade. Again, think in terms of the big picture. You do not need to make money on a single trade; the overall results across a series of trades are all that really matter. When starting a new endeavour, it is natural to want to do well on every single attempt. All of one's hopes and dreams may be placed on a few key trades, for example. But trading is much too difficult to think you can quickly make a few trades and be set for life, with all your aspirations met. The successful trader is in the game for the long haul. The trading lore is replete with stories of traders who made huge profits only to lose it all later. You may see some big trades in your career, which will provide numerous war stories that you can use to entertain your friends for hours, but when going into a trade, it is vital to keep the trade in proper perspective. It is still just one trade of the many you will make in your career.
Living to trade another day
“I blew out my first trading account in college. It is almost like you have to, but hopefully with a small amount of trading capital," says Manuel. In interviews with novice and seasoned traders alike, you would have heard the same thing, as well as in classic published interviews like "Market Wizards." It is just a simple matter of mathematics. If you risk too much, and do not make enough winning trades, you end up in the red sooner or later. But mastering the markets takes time, and it is in your best interest to survive to trade another day.
Survival is key when trading the markets. Whether it is surviving a learning curve as a novice trader or surviving new market conditions, every trader must face his or her long-term prospects. The difference between winning traders and those who end up leaving the profession altogether has to do with how they approach this eventuality. The winning trader is aware and prudent when it comes to long term goals. The trader who blows out, in contrast, is in a state of denial, afraid to assess his or her current financial situation and take precautions to survive.
The winning trader is aware in that he or she admits that trading is risky, and that profits are not assured. He or she admits the risk and quells a gambling mentality. When a trader is afraid to face the odds of losing, though, the hidden, unexpressed fear of possibly blowing out gnaws at him or her. These unexpressed feelings of impending doom can frustrate you and thwart your efforts at the worst possible moment. When fear lurks in the back of your mind, you may unknowingly act impatiently and impulsively. You may tend to think, "I'm tired of looking for profitable setups. I cannot wait for the ideal market conditions any longer. I am just going to execute a few trades and hope for the best." Taking such a stance toward trading does not work in the long run, however. If you want to master the markets, you must prudently plan ahead.
What kind of plans do you make? Do you acknowledge how much you win and lose or do you dread facing how well you are doing and feed your trading account each month? It is all right to lose and it is all right to feed your trading account, but it is vital that you are fully aware of your actions.
Realistically, however, it is necessary to make sure that you are well capitalised. It takes money to make money: That is a reality of trading that you cannot ignore. In addition to carefully accounting for how much money you have to trade, it is necessary to always look at your risk-to-reward ratio before executing a trade. Make sure that you have a reasonable chance of making a profit. Some trades may be too risky for you to take. They may be sound and have a high probability of success, but unless you have adequate trading capital, they may not be right for you. And if you execute them, you may not survive the worst case scenario. It may be better to find a trade that you can afford to take based on your available capital, rather than risk money you can't really afford to lose. By looking at your financial situation realistically, you can take steps (such as standing aside or getting a second job to build up adequate trading capital) to make sure you survive the learning curve and master the markets.
Losing may hurt, but you will survive
It's amazing how many traders have lost big before they became master traders. Trader David Kyte notes, "experts in losing are not life's losers." It's ironic, but to be a winner you have to learn how to lose. "Winners have far more experience losing, because they get up over and over again. A loser only loses once, that's why he is a loser.". True losers in life are afraid to take chances. They live under the assumption that winners face win after win, but little do they know, a winner faces many more setbacks than successes.
David Nassar observes, "Losses are inevitable. They are as common to active traders as strikeouts are to major league baseball players. Ballplayers who cannot deal with striking out or traders who become depressed by repeated losses are doomed to the bush league."In interviews with successful traders, many have reported experiencing significant setbacks before mastering the markets. Dan reported, "One time I lost virtually everything in one or two days...I think I lost four or five hundred thousand dollars or something like that." It was a severe setback, but Dan knew how to lose. At the time, he thought, "It's only cash. It's not my life that I lost. I can get it back. It's not the end of the world. I'm not losing my house, my car, my credit cards, or my friends." Similarly, Don described the setback he experienced when he first started trading full time: "I went from trading to provide supplemental income to trading to put bread on the table for a young family...The first month was a disaster. It was an absolute disaster. In about four trading days, I gave back about 70% of what I had made in the five months preceding my decision to trade full time. At that point, I went through my own personal abyss that I had to pull myself out of."
Losses and setbacks are part of life. In all walks of life, people work extremely hard to pick themselves up after setbacks. Have you ever asked a salesperson how many calls he or she had to make before getting a sale? In some cases, less than 5% of the calls lead to a sale, but if just one of the cold calls pays off big, then it was worth all the effort, right? Cornell psychologist Dr. David Dunning notes that many people are unaware of the time and effort it takes to be successful. Many college students, for example, believe that reading a book just once is sufficient, and because they "studied," they feel they should get an A mark. But ask the valedictorian what he or she did and you will find out that he or she didn't merely read the book just once. Indeed, I once asked a valedictorian of a competitive university how she was able to get an A mark in every class. She said she read every reading assignment four times to make sure she got it right! If you ask traders how much time they put in, you'll find the same thing. Winning traders spend most of their time "insanely focused," as Bill Lipschutz describes it, in that they put in late hours studying the market action. They put in more time and preparation than you might imagine, but do they always win? Unfortunately, many times they lose. Losing is not the problem, but getting extremely disappointed because you lost is. It is useful to think optimistically. If you put in enough hard work and effort, and repeatedly pick yourself up after setbacks, you can master the markets.
Mastering the markets is challenging. Many people try to trade profitably, but few make it. Perhaps the single most significant factor in mastering the markets is the burning desire to win. Winning traders do whatever it takes to win.
Caught off guard
Whatever can go wrong will go wrong. That is Murphy's Law. Many people view this sound piece of wisdom as reflecting a pessimistic outlook. They like to look at life through rose coloured glasses. But looking at life without anticipating the downside will spell trouble when trading the markets. Optimism is powerful, but it must also be firmly grounded in reality. Things go wrong. That is a fact of life, and unless you plan for things going wrong, you will be caught off guard, and it will mean the end of your trading career.
What can go wrong? You name it. Your computer can break down. Your Internet connection can fail. A world event may impact the markets as a whole, and thwart your trading plan. You may get up on the wrong side of the bed, feel overly stressed, and choke during a critical moment of investing. Again, if anything can go wrong, it will. Rather than feel paralyzed, however, it is vital that you take precautions. When you are stressed out, it is easy to make dumb little mistakes. You can trip over your monitor cable and knock it down, or you may be unable to use your mouse properly. You think it sounds unlikely? It happens, especially when an adverse event catches you off guard and you panic. When you are not ready for something to go wrong, you are likely to be thrown off balance to the point that you cannot gracefully become reoriented.
The best way to stay focused on any possible trading outcome is to consider all possibilities, so that our expectations are realistic rather than naïve and Pollyannaish. When our expectations do not match what actually happens in our lives, we react emotionally and often impulsively. For example, although we have a natural human desire to win, we often face loss after loss as a trader. Trading is a profession where you should work under the assumption that you will see more losing trades than winners. Expecting to win is likely to produce more disappointment than euphoria. To the novice trader, especially, this fact of life can be stress producing and somewhat disappointing. But trading is not the only profession where one must face undesirable outcomes, and learn to cope with them. Many professionals must deal with everyday events that are distressing and hard to accept. (Consider baseball, for example; hitting only 30% of the time is great.)
How one copes is all a matter of the expectations one has, the outcomes one anticipates. Many times, setbacks are the rule, and without the proper mind-set, such setbacks can be paralyzing. As a trader, it is vital to have the right mind-set. Rather than assume that one can make easy money by acting on half-baked trading plans, it is essential to be realistic. It will take a great deal of preparation to find good trading opportunities. They are out there, but one has to do the necessary work to find them. And when you find them, and try to capitalize on them, they would not always produce a win. That does not necessarily mean you should be disappointed. If you realistically anticipate such setbacks, you would not be caught off guard psychologically. If you expect a loss, you will be able to accept it more easily and you will take precautions, such as proper risk control, so it would not wipe out your trading account balance.
Similarly, if you know your Internet service tends to fail, you will develop a backup plan. Perhaps you will get a cable modem as well as a ADSL line. Why not have a spare laptop computer up and running in case something happens to your main computer? If you know that you are easily put into a grumpy mood, take precautions to put yourself in a good mood when the trading day starts. Get extra sleep. Skip a trading day if you need to and get plenty of rest before you tackle the markets in earnest. Trading is a field where a few mistakes may require you to spend a great deal of time repairing the damage. So it is vital that you minimise the potential damage up front. Take whatever precautions you need so as to ensure that you can execute your trading plan flawlessly.
The traders who do not anticipate every possible adverse event are the traders who end up losing in the end. There is nothing pessimistic about working under the assumption that a number of things can go wrong, and so it is wise to take precautions. If you are ready for anything, you will be likely to survive. If you are caught off guard, however, you will be likely to lose, and lose big.
Panicked and stunned
John is in a panic. He has been pushing himself all month to reach a specific financial objective, but he cannot seem to make it. In a last ditch effort, he has made a big trade and he is ready to execute it, but he cannot get it done. He is so anxious, agitated, and frustrated that he cannot do the most simple task. John is having a trader's panic attack. He is so fearful that he just cannot function.
Have you ever felt like John? When fear sets in, your body reacts with such agitation that nothing seems to go right. You start doing dumb things. Even the most commonplace task cannot get done, or you make stupid mistakes, like closing the wrong trade or reading a chart incorrectly. You can be so agitated that you accidentally kick the power cable for your computer out of the wall socket. The human body is wired to panic at times. There are vast individual differences. Some people are calm no matter what, but others are easily unnerved. Nevertheless, when panic sets in, our attention is truncated and our options are limited: We either stand up and fight or run away to save ourselves. These are the two basic instinctual responses when panic sets in. Some traders react to panic and frustration by throwing their mouse out the window. That is how basic the human animal can be at times. But again, there are vast differences. There is no one right way to trade and many different viable trader personalities. The limitation is not in having the "wrong" personality for trading. The limitation is in trying to be someone that you are not. If you are easily panicked, it is vital that you identify this potential drawback and work around it.
Look at your personality closely. Are you the kind of person who may have a trading panic attack? Do you get so agitated at times that you cannot think straight? If you are prone to such a malady, you can work around it.
- Limit your risk. The more you have at stake, the more agitated you are likely to become. If you risk little, though, you will know in the back of your mind that you can handle the worst case scenario. It will calm you down.
- Always remember that you can scale back your financial goals if necessary. If you cannot reach your goals, do not worry about it. Do what you can do. You will find that your feelings of agitation are greatly reduced when you set more modest goals.
- Use a stock broker if you need to. Although we are in the midst of a technology boom, many professional traders still call their stock broker to place a trade. It may seem old fashioned, but some traders realise that actually placing trades puts them on edge. They know that they feel calmer when someone else actually puts their money on the line.
You do not have to be the ideal trader to profit in the markets. Indeed, the myth of the ideal trader is just a myth. There are many different kinds of people trading the markets profitably. The key to success is to be true to yourself. Gauge what your personality is, and work around it if necessary. Do not be afraid to be yourself and to take steps to change your trading methods to suit your personality. If you are prone to anxiety attacks while trading, scale back and calm down. You will find that you can think more clearly and trade more profitably.
If you have only been trading for the last 4-5 years, you might chuckle at the idea of trading based on value. It was during these past years that technical analysis became the standard for making trading decisions. For those who have been trading for a lot longer, you can recall the days when the value of a company was figured into the analysis to purchase or sell. PE Ratios, Earnings Per Share, Goodwill - investors and traders actually looked at these figures. Analyst commentaries were analysed and trading plans made accordingly. The most successful of traders were known for their hybrid technical/value plans. The recent "scandals" of WorldCom, Enron, and the hundreds of lawsuits against .com companies are evidence that a lot of this material information has been overlooked for a long time. When the dotcom excitement took the markets by storm, the perception and sentiment for how a trade should be made changed. Initial public offering (IPO) after IPO, people invested in companies without even having an understanding of what the companies did. Hundreds of thousands who were making money were convinced that they knew how to trade. After all, they made profits so easily. But today, almost all of these people have fallen by the wayside and taken up other careers after suffering tremendous losses.
The markets have changed, and as a trader, you need to recognise and understand these changes. From experience, you are likely to know that the market patterns tend to vary every few weeks, sometimes every few days, differing among sectors and specific issues. Those who have very long-term experience also know something else about the markets, something that most inexperienced traders overlook. This is that market patterns also change on a much grander scale, over decades, from a much more overview perspective. We are right now experiencing changes that are going to be known as critical and major turning points in the economics and business climates of the world. Does this mean value investing is going to play a bigger part in trading plans? It is difficult to say, but as a trader, you always have to be on the lookout for changes in the markets. Consider how value investing might begin to play a role in your trading. Be prepared to adapt your plan to stay in sync with the markets.
Risk taking versus risk seeking
Prominent business leaders often portray themselves as risk takers. There are numerous anecdotes of entrepreneurs who put it all on the line, took a big risk, and made a big win. There is some evidence, however, that successful entrepreneurs and traders are not risk takers at all. Indeed, those who are successful in business are more likely to avoid risk rather than seek it out. A dictionary definition of risk is: "a course of action that involves danger or hazard." To some extent, anyone who makes a trade is taking a risk in that it is possible that a great deal of the money can be lost. This loss is a danger or hazard.
Risk takers can be distinguished from risk seekers, however. A risk taker is someone who exposes himself or herself to a risk, such as when a person makes a trade. A risk seeker, in contrast, is a person who likes risk, seeks it out, and enjoys the thrill of taking a risk. A risk taker does not necessarily need to be a risk seeker. Successful traders may be willing to take a risk, but they do not seek them out. They are not gamblers who enjoy the thrill of the possibility of losing a great deal of money. Instead, they take a calculated risk. They minimise the amount of risk on any single trade and look at the potential downside of a trade. They consider the possibility that one may face a series of losing trades and should this happen, they assess to have enough capital in their trading account to make it through this run of bad luck. By risking only a relatively small amount of capital on any single trade, they protect their capital should they face several losing trades.
In contrast, risk seekers are people who do not look at the consequences of their actions. Risk seekers often act impulsively, and approach each trade as potentially the one big trade that may set them up for life. The risk seeker is ready to make a big bet, while the successful trader may be willing to take a risk, but not that much of a risk. Successful traders also have different expectations regarding how the capital in their trading accounts increases. Risk seekers hope that their capital will increase rapidly, but successful traders are willing to let their capital increase in a slow steady linear fashion. They know that success comes in small steps. Risk seekers' capital tends to increase and decrease in a jagged pattern, and usually ends up an overall decrease, rather than an increase.
When you are trading, do not take unnecessary risks. Remember, successful traders may be risk takers, in that they are willing to lose a small amount of money, but they are not risk seekers. They want to limit their losses on any single trade, make a slow but steady profit, and patiently wait for their capital to increase.
You have invested 25% of your trading capital in a share that your analysis had predicted would increase. Your expectations have not been supported, however. The price has been steadily declining. You think, "I did such a careful and detailed analysis. I have spent a lot of time studying the fundamentals of this company. I cannot believe it is going down." At this point, you may hope that the position will reverse, and refuse to close it out. It is easier to keep it open than face the regret of a bad decision and accept the loss. This is called the sunk cost effect: A person increases one's commitment to a losing position because a great deal of time, effort, and/or money has been spent. The most obvious and blatant example of the sunk cost effect is when we have invested a large percentage of our capital in a losing position and we do not want to admit that we have lost what we have invested. However, there are other more subtle ways of experiencing the sunk cost effect. Most people do not consider them, but they may still influence investment decisions.
The old adage "time is money" illustrates how there are other ways that one can "lose money" by just putting in time and effort into an investment. For example, let us say that you research a particular company closely. You read reports on the fundamentals of the company, and you follow the share price on a daily basis, noting price changes that correspond to company announcements and significant events in the industry. The more effort you expend on preparation and analysis, the greater the sunk costs you will experience. There is a strong tendency to justify the time and effort you have expended. Why spend so much time and effort studying this company if you do not plan to invest in it? This tendency to want to justify your behaviour will gnaw at you, and if you are not aware of it, and are not trying to control it, you will have a tendency to want to invest (long or short) in the share, even when you know you should stay out, and wait for another opportunity. It is useful to be aware of this subtle effect. Ask yourself, "Do I want to invest because I see a real opportunity or am I merely trying to justify the amount of effort I have put in?" It is important to be aware of how this subtle yet powerful influence can lead you to make a decision you will regret later. Overcoming this subtle influence is difficult. It is a good idea to study companies closely and capitalise on an opportunity when one arises, but do not overdo it. Remember that expending too much effort has a subtle impact. Try to overcome it. Remind yourself that you do not have to invest. Your research and preparation will pay off big someday, but learn to wait for the right opportunity. Be aware of both the subtle and blatant ways that the sunk cost effect can influence your behaviour. Try to consider whether or not sunk costs are influencing your decisions. Try to rationally counteract them, and prevent them from getting the best of you.
Extreme price movements are a common pitfall for inexperienced and emotionally sensitive traders. For the last several years, we consistently saw extreme volatility in the markets. Some traders adapted their approach to take advantage of it while others were pushed out of the markets. When you expect a certain level of volatility, you can set stop losses and profit objectives accordingly and be less likely to succumb to emotional reactions. But when the markets are not consistently volatile and you have the occasional extreme price movement, it is far more difficult to properly manage your trade and stay clear of your emotions. In response to this idea of extreme price movement being a potential pitfall, many traders will be quick to say that stop losses are there for protection when there is an extreme price move against their position. More experienced traders might chuckle at that..."Good luck with making your exit trade. Prices will be far beyond your stop loss points before you can get an execution." It is true that stop losses will help to gauge your situation and can give you a target price to at least try to exit at. But it is also true that when there is extreme price movement, it is very difficult to get the execution you need.
Generally, when the extreme price move is against you, it is more profitable to wait it out. When there is a big change in price in a very short amount of time, there will usually be, at the very least, a small retracement, giving you more control over an execution at a better price. There is one key exception to this. If your position is in line with a strong mass consensus (especially with high speculation) and the extreme move challenges the reasoning behind that consensus, you are usually far better off exiting as soon as you can.The flipside of the extreme price movement pitfall is that the price very quickly makes a big move in your favour. In these circumstances, you are likely to get a quick execution too soon. If you wait too long to exit, you might lose the advantage and end up getting an execution at a worse price, on the retracement. In these cases, it is generally more profitable to try to get the best execution before the momentum of the move dies down. Familiarise yourself with the volatility level of the share you are trading and incorporate "rules" for these situations in your trading plan.
Every good trader has a system or methodology for determining stop losses. Such systems are usually sets of formulas and criteria by which stop loss levels are automatically set. Experienced traders go a step beyond the concept of the stop loss by using trailing stops, which as part of the exit technique, the formulas and criteria used are very important to the success of a trade. Inexperienced traders often make the wrong choices when it comes to establishing a stop loss methodology. In an effort to automate their stop loss determinations, they tend to use over-simplified formulas and/or criteria, to the point that they apply an ineffective formula believing that it will work. In such cases, their stop loss methodology becomes a generalised, mechanical system that does not address its purpose. This results in miscalculated stop loss levels, which will cause the trader to exit out of a trade either too early or too late.
One of the most common and simplest methods of setting a stop loss level is to set the level as a percentage of the entry price. For example, a day trader may decide that if the price reverses by 2% of his entry price against his position, he will exit. This type of simplified model is not very useful. If the trader is trading in high levels of volatility on a particular day, his stop loss levels will be completely ineffective and will cause him to make the wrong choices. Additionally, this type of methodology does not incorporate the trailing stop technique. To use a trailing stop in this example, the trader would have to adjust what he considers his entry price as the price moves in his favour. For example, if the price went up 2% in his favour, he would consider his entry price to be at the 1% mark, and therefore his stop loss levels would shift. The primary purpose of your exit formula(s) is to identify the point at which your reason for entering the trade is no longer valid or at which letting your profits run beyond your profit objectives is no longer justified. And since you will have different reasons for entering different trades, having a set of exit formulas will allow you to choose the right one depending on what reasons you entered the trade with.
Discipline and self-control
You have probably heard it countless times: "Discipline is a key factor in trading success." Discipline is mentioned in almost every trading book and in the title of many. Why is discipline so crucial? Trading is largely a matter of capitalising on odds. Assuming a given trading strategy has a past performance record of 85%, for example, it is a matter of odds that the particular strategy will obtain that record in the future. It may not. Unanticipated factors, such as a change in market conditions can go against the strategy, diminishing its performance record. A lack of discipline makes matters worse. Assuming the strategy does have a high probability of future success, the only way to take advantage of the law of large numbers is to execute the trade flawlessly on as many occasions as possible and as defined by the guidelines of the trading plan. The disciplined trader decisively trusts the strategy enough to commit funds to the plan, and gives the plan a reasonable chance to capitalise on the odds. The undisciplined trader, in contrast, wavers. He or she follows the trading plan inconsistently, trading the plan occasionally while going a different way at other times. Discipline is indeed a key ingredient to success, but not everyone has a high level of self-discipline. It is worth determining where you stand on this trait and, if you lack discipline and self-control, work to build it up.
Discipline and self-control are well-studied personality traits. Some people are highly disciplined and very self-controlled. They scrupulously follow rules, and are careful to control their impulses. You know the type; they pay off their credit cards every month, are never late for an appointment, and carefully plan every detail of their lives. Although these characteristics may be ideal for trading, there is a downside: Such people tend to have trouble taking risks. They prefer a sure thing, and trading outcomes are rarely sure things. Traders tend to prefer living a little on the wild side. They may not recklessly seek out risk, but they do not mind it. Relatively speaking, they tend to lack discipline and control. Perhaps that is why so many trading books and coaches find it necessary to preach the virtues of self-control. How is your discipline and self-control? Do you have trouble sticking to your trading plan? Do you long for more discipline and self-control when it comes to your trading?
If you have trouble with discipline, you may want to try a stimulating exercise to increase your awareness: Observe your level of self-control in your everyday life and try to gain more control. How much discipline and self-control do you practice in your everyday life? Are you late for appointments? Do you spend more money each month than your budget allows? Do you frequently find yourself breaking promises? It is not necessarily the case that a disciplined trader is disciplined in all aspects of one's life, but it helps. The life strategies we use in everyday life may bleed over into our trading life. If you often overspend, overeat, or have an unrestrained need for pleasure, you may find maintaining self-control and discipline while trading a little more difficult than others. So try this exercise: spend a few weeks trying to control as much of your life as possible. Pick specific areas where you can gain more self-control. Control your calorie intake, the money you spend, and time spent in leisure activities. See how well you do. It may change your reference point. You may soon discover that you rarely control your impulses, and can do much better. And this in turn may positively influence your ability to stick with your trading plan. It is worth trying. Discipline is the key to trading success, and it is vital that we do everything that we can to increase it.
The breakeven point
Once a trade is entered, there are two possible outcomes: on the light side it can make money; on the dark side it can lose. Between the light side and the dark side is the breakeven point, and because it is in-between, it has psychological significance. It separates fear and hope on the dark side and greed on the light side. The side you are on determines how you see this fulcrum. When on the dark side of a trade, the breakeven point is a spot of light that inspires hope. Humans have a natural tendency to avoid risk and loss. When in the midst of a losing trade, many tend to hold on and hope that the loser will turn around and return to the breakeven point, where there may be no profits, but at least there are no losses. But hoping often leads to losses in the end. Hope has no place in making trading decisions. When putting on a trade, the entry point and the protective stop should be calculated up front. If this is done properly, there is no reason to let hope, or any other emotion, influence your trading decisions. You should trade almost mechanically. If the trade goes against you, simply exit once the stop price is hit. Do not let hope play a role in your trading plan. There are many good reasons to cut your losses, rather than hope for the loser to turn around. When you are in a losing trade, you are rarely alone. Many other traders are also long, for example, trying to exit without a loss. And there are shorts defending this area to protect profits. It is unlikely that you can be the victor of this contest, so the best choice is to just cut your losses, and move on to the next trade.
The vantage point from the light side is quite different. In the midst of a winning trade, traders tend to take profits too early, again because they are averse to risk and potential loss. By exiting early, however, they do not let their profits run. This limits the size of the winning trades, so that across a series of trades, the overall profit is diminished. But there is a way to lock in profits, let the trade run a little longer, and pile on a little more profit. Once the profit exceeds the initial stake, a stop can be placed at the breakeven point. This strategy lets you lock in some initial profits while virtually eliminating risk. The most you can lose is brokerage costs. Besides reducing financial risk, the emotional stress is also eliminated. And reduced stress means you can evaluate the bigger picture more objectively.
Unfortunately, many novice traders are so consumed with capturing a profit and showing a green profit/loss statement that they cannot follow through with moving the stop loss to the breakeven point. They feel the strategy inhibits them and may limit their potential profits. They wrestle with moving the stop loss back to its original point, where they entered, or simply cancelling it altogether. This can be disastrous to a trading account. Stop losses should never be changed to a more harmful position or cancelled altogether. Such practices will stir up emotions that adversely sway trading decisions, and eventually lead to one's demise. Discipline is always the best strategy. Whether on the dark side or the light side of the breakeven point, it is useful to realise its psychological significance. When on the light side, you will be motivated by fear and hope. While on the light side, you will be motivated by greed. It is vital to recognise these emotional tendencies and do everything possible to counteract them and remain objective.
The dot-com craze produced quite a few instant millionaires, but many of them lost it almost as quickly as they had made it. These days, perhaps some of them wish they had spent a few of those profits on things they could still enjoy. There is the story of a high school pupil who held 550 000 insider shares in a company he helped found, a maker of Internet hardware. The company went public at around $16 a share, and then moved steeply higher over the next several months to a peak of around $120. At that price, our hero was worth roughly $66 million; on paper, that is. You would think that he would be retired and playing golf three times a week, but in fact he works a 9 to 5 job like most of us. Nearly all of his shares were restricted for sale during the share's meteoric rise and fall, so he was unable to realise the kind of capital gains that might have allowed him to retire rich.
The only evidence that remains of his fleeting wealth is a $5 million home in the Boston suburbs that he bought for cash. He makes enough now to maintain the home and pay the taxes on it, but he could not afford to buy it today if it were on the market. The lesson here is that the fantastic
profits that can be made in the share market are just a lot of ones and zeroes on a computer's ledger sheet if we do not spend them. Some traders evidently think that is what the game is all about; amassing lots of ones and zeroes to keep score. But those who think this way are apt to become bored quickly if the electronic profits do not keep piling up at an ever-increasing rate. If you are trading profitably, consider rewarding yourself now and then with something that you can truly enjoy, whether it be a box of Cuban cigars or a fantastic holiday with your spouse in Mauritius, or a fancy new home entertainment system for your home. It will help to remind you that all those trades you sweated bullets over were worth the anxiety.
Let us say you are down ten thousand Rand. You may think, "Oh gosh! I just want to get that money back." You do not want to end the day down ten thousand Rand, so you are not coming to the market to win anymore. Your attitude shifts and you are now coming at it not to lose. Pretty soon you end up down R50 000 and you think, Oh my, gosh, that could have been a trip to Jamaica. All that time you have just been digging. But the first thing you have to do to get out of a hole is to stop digging! And the best way to stop digging is to throw the shovel down. You just have to say, "I am done for the day and I will come back tomorrow when it is a brand new day." So many people take a really small situation, where they are only down a thousand or so, and they turn it into a loss of ten thousand trying to get that one thousand Rand back.
Some successful traders will use a stopping point of few thousand Rand loss. If they are down that much then they are done. They just cannot stomach losing that much or they will start doing stupid stuff. They get away from the market. They go running or they work in the garden. Because if they are sitting there watching the market, they are still going to be involved and they might say, "Oh, wow, that is a perfect trade! I have to take that." But they know that their mind is distorted at that point. It is probably not a perfect trade. It does not take them very long to get over it. Once they are away from the market, they get over it pretty quickly, but if they keep staying there then the situation just gets worse, and worse, and worse.
How do you talk trading?
If you are a part or full-time trader, you may have enjoyed the attention this wild and woolly occupation brings at social gatherings and events. Many people are interested in share trading, and find you interesting as a successful trader. At first, the attention may be enjoyable; but a need to maintain this reputation may impact your trading attitude and mind-set, and thus, your bottom line. The best strategy we can use to avoid letting our reputation influence our performance, especially when enduring a drawdown period, is to keep our conversation low-key about our trading careers. Why? The more you present yourself socially as a "successful trader," the more psychological effort you will spend defending this reputation. Several research studies have documented that one of the biggest obstacles to sound decision-making is the need to save face in social situations. People are so reluctant to face the adverse social consequences of having made a poor decision that they stay on a losing course of action, rather than admit they were wrong. For example, some traders are reluctant to sell off losers in order to avoid the possible social criticism that acknowledging a failure may bring.
Suppose that you have told your friends about a large trading position, and the next week, it tanked, hard and fast. Most folks cannot wait for the next opportunity to ask you (even though they probably know the answer) how your "hot stock" is doing. If you sold it, at least you have the solace of managing the trade properly... even though you must tolerate a volley of smug "you-thought-it-would-go-up, but-it crashed-instead" comments. On the occasions when you ignored your protective stop loss, however, and held onto the bad trade, the "Boy, you-really-ARE-dumb" looks (and perhaps comments) can exacerbate the psychological devastation you have by now, surely, inflicted on yourself. And we all know the negative impact a negative attitude can have on our trading. As another example, how many times has the market gapped up, then chopped through the rest of the day, handing you more losses than wins? Inevitably, those are the days when well-meaning friends call on the phone. "You must have made a fortune today!" they gush. "Not really," you mumble with a sinking heart, remembering the frustrating trading environment. After you hang up the phone, the subsequent feelings can lead you to believe that you must have been a dope that day; surely every trader in the world except you grabbed huge gains. In social environments, once you announce and identify yourself as a trader, you will feel a need to defend your reputation. Trading is hard enough, why introduce additional social and psychological pressures that will adversely influence your trading results? Keep the specifics of your trading career to yourself. There is no sound reason to discuss the specifics of your career socially. It is often done just to build up your ego, and enjoy the attention of others. You will pay a price for this short-term gratification in the long run. Avoid specific observations or trading choices. That way, you will avoid embarrassing questions and comments that will interfere with your trading.
Develop your skill set - taking a loss
We are all proud of the skills that we develop as traders. We work on execution skills with enthusiasm, practising speed and precision. We pour over technical charts for hours, study technical indicators and oscillators and possibly even alter standard defaults to see how it impacts the signals they give. Some of us happily work on complex trading systems, labour well into the evening hours calculating complicated formulas, then spend more time back testing them. Others comb through reams of fundamental research to support our technical decisions. Few of us, though, spend quality time developing our skills at taking losses.
Why? Because losses require us to admit that we are wrong. And we naturally associate being wrong with pain. But it is a healthy and profitable concept to reconsider our losses in an entirely new light. What if we declared a different truth to ourselves? "The more highly skilled I become at taking losses at appropriate times and according to my plan, the more profitable trader I will become." In The Disciplined Trader, Mark Douglas suggests, "Execute your losing trades immediately upon perception that they exist. When losses are predefined and executed without hesitation, there is nothing to consider, weigh, or judge and consequently nothing to tempt yourself with. There will be no threat of allowing yourself the possibility of ultimate disaster."
To shed a new light on losses, try "re-circuiting" your brain and develop loss-taking into a skill, instead of an unhappy and painful event. First, accept the fact that losses are the norm rather than the exception in the trading game. You should expect to lose. Own that reality which will help take the fear out of it. Second, make sure to define your losses (risk) before you enter any trade. Define your possible loss, or risk, in comparison to your possible reward, or profit. The proper ratios of these two are what give you the statistical edge. Now you are in control of your trade, not the other way around! Third, practice exiting your losing trades with precision and accuracy. Finally, confirm, realise and internalise that without a doubt that your controlled losses do not reflect on you, or your personal worth. They are a compartmentalised component of your business.
Trading capital - size matters
How much capital does one need to start trading? Every person who is new to trading asks this question. It is often the first question that pops up from prospective trading clients. But is it the right question to ask? The answer may not be as obvious at it seems. Viewed from a conventional standpoint, one might think that all you need is the minimum amount required to open a trading account by your brokerage firm. The regulators set minimums that vary according to whether one will be trading shares, CFD's, options, futures contracts or perhaps a combination of these vehicles. It is important to realise, however, that merely meeting the trading account-size minimum does not necessarily put one in good stead to begin a trading career. A more important question should be asked up front: How much money do I need, not in my trading account, but in my bank account?
Of course, this is very different from asking how much one needs to merely start trading, and answering the question may require a degree of personal reflection that goes much deeper than calculating how much to put in a trading account. In fact, if trading CFD's, it is theoretically possible to make R1 000 to R2500 or more in profits per day with just R10 000 in a margin account. But does this mean that someone who can meet the minimum requirement is in excellent shape to trade? Not necessarily. Suppose a novice trader has R10 000 to open a margin account, but not a cent more to put into it if he or she should lose it all by trading poorly? Under such circumstances, the loss of such a sum, hardly impossible, even for someone employing conservative trading strategies, could end that person's trading career. Could one expect to trade well under such a threat? Probably not, since confidence is crucial to anyone who would seek success at trading, and few things undermine a trader's confidence so thoroughly as a nagging fear of losing one's stake. It is like trading with a gun to one's head, and it metaphorically describes the trader who is barely able to cover monthly household and business expenses while honing his or her skills. It is a problem that has tripped up many a beginner, and it makes success far more difficult to achieve when steady profits are needed just to pay one's bills. It is far better for the new trader to be financially secure from the start, secure enough so that an entire year spent without profit on the learning curve would not impact one's lifestyle or threaten one's financial security.
So we should not fool ourselves into believing that merely meeting minimum trading account-size requirements will suffice. In fact, if it costs you R200 000 per year on average to meet all household expenses, then you should have at least R200 000 in liquid savings to see you through your first year of trading. This, of course, is in addition to the sum you will use to fund your trading account. Having a sufficient sum in the bank to meet a year's worth of living expenses will provide a cushion against adversity, as well as a psychological bulwark against the ups and downs that are a normal part of every trader's learning experience.
Top-down versus bottom-up stock picking strategies
What is the optimal way to pick a share? Should you use a top down approach, where one evaluates the broader economic trend before considering an industry (i.e. mining, financial and industrial), then the sectors and then, a specific share? Or should you use a bottom up approach, where one starts by looking at individual share characteristics, before looking at the sector, the industry and then the broader economic picture? Both strategies have their advantages, but the one you decide to use depends on your objectives. In a top down approach, the goal is to pick a share that will outperform general economic trends. By looking at the general economic trend first, one can then determine which specific industries or sectors will outperform the general trend. Shares that are attractive within that industry sector are then purchased. From a technical analysis point of view, a top down investor first analyses the trend of the entire market, followed by the trend of the sector, and finally the trend of specific shares. A bottom up approach is more like a treasure hunt. One looks at the shares first, followed by the sector and then the market. A fundamental analyst might begin the hunt by sifting through hundreds of shares, screening for candidates with a low P/E, high dividend rate or examine dozens of other available quantitative studies. A technical analyst will either scan an equally large number of charts for breakouts, breakdowns, pullbacks, snapback rallies, unusual volume activity, or hundreds of other technical indicator studies.
So which approach is better, analysing the macro picture first or taking a look at the individual shares first? The answer is not clear-cut. It depends on your objectives and anticipated time in a trade. For short-term trading, however, a bottom up approach is preferred. Similarly, you should also look at individual component or index shares of a sector before looking for confirmation by a strong index price. When trading in the short term, it is crucial to remember that timing is important. And since certain component or index shares tend to lead any particular index, the bottom up approach will help you identify the best opportunities.
The golden mean - real trading phenomenon or just wishful thinking?
If you have spent any time around trading, you have probably run into the Golden Mean. You may have seen it represented as Fibonacci lines on a price chart. The Fibonacci sequence is a string of numbers in which two consecutive numbers are added together to produce the third, for example, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, and so on. Some traders use ratios derived from the Fibonacci number series to define key support and resistance levels, often with the belief that such estimates are more "natural" because they are based on the Fibonacci sequence. Fibonacci claimed that consistent patterns could be found in what appeared to be random numbers. Subsequent followers of Fibonacci extended his theory to the trading of futures and shares as they attempted to find patterns in random price activity. But are there "natural and pristine" patterns in the seemingly random movements of prices, or is it just wishful thinking?
One way of calculating the Golden Mean Ratio is to add two random numbers together. That result is then added to the sum. After eight reverberations, one can divide the former number into the latter and find a definable pattern, which is represented mathematically as 0.618 or its reciprocal, 1.618. This Golden Mean is thought to reside in the most beautiful architecture, music and art. It is commonly found in nature in the structure of many of the most beautiful flowers, animals, and seashells. Greek philosophers and mathematicians saw the Golden Mean as significant because it illustrated balance in nature, the arts, and even the human body. It was the epitome of balance, the perfect shape … the most pleasing vision. In the natural world, it is amazing how consistent patterns abound, but when it comes to human behaviour, social scientists have long known that such consistencies are rare and almost non-existent. And what is trading? It is human behaviour. It is not a natural phenomenon, but made up by humans. It is not perfect. It is not pristine. It is in disarray and unpredictable. To be a successful trader, one must accept the uncertainty of human behaviour and engage in the daunting task of finding consistency where there is little.
Nevertheless, many traders find ideas, such as the Fibonacci number sequence, fascinating, almost mystical. But not all traders appreciate the beauty of the Fibonacci number sequence. Indeed, the editor of a popular trading magazine once noted that there might be nothing mystical about the sequence. It may seem to work merely by coincidence (the market is likely to correct somewhere between one-third and two-thirds of the previous trend, which is similar to the commonly used Fibonacci ratios of .382 and .618.) Where you stand on such issues may reveal a lot about your trading personality. Many traders are drawn to the superstitious aspects of trading. They do not have confidence in themselves, so they start searching for methods based on the "laws of nature" that can give them a solid, yet false, sense of reassurance. They seek out universal and general rules, all in an attempt to seek out certainty and the security it provides. Concepts, such as the Fibonacci number sequence, do just that. They offer promise.
One has the luxury of not believing in oneself, but in the greater omnipotent laws of nature. It is like believing in luck, fate, or destiny. One can chose to live one's life passively believing in external forces, waiting for the proverbial stars to line up in one's favour. But the most successful members of society do not have time to wait for fate or to depend on luck. And if you want to be a profitable trader, or stay that way, it would be wise to abandon any forms of superstition. The surest way to success is to build up your trading skills. Build them up to the point that you cannot wait for so-called "luck" to move against you so that you can demonstrate your actual fortitude. With solid trading skills, and the rock solid confidence it will give you, you will find that you can accept the uncertainty involved in trading the market, and depend on you, your skills, and nothing else.
Controlling fear by controlling risk
Fear protects us. If you touch a hot stove and get burned, you learn from your mistake, and you never do it again. But some people never learn, especially when it comes to trading. They make amateur mistakes over and over again, like trading with money that they just cannot afford to lose, or abandoning risk limits and making large, risky trades to make back money they have lost on a few bad trades. The fearless trader may end up as a losing trader unless proper risk management is used.
There are psychological advantages to risk management: When you know you can handle the worst-case scenario, you will feel more at ease, and you will trade more creatively. One of the most popular ways to limit risk is to restrict the amount of trading capital you risk on any given trade to 1%-2%. How do you precisely limit risk? First, you should have a well-defined trading plan in which you estimate the potential profit you could make, and at the same time, know how much you could potentially lose. The range at which a stock trades over a specific time period, for example, can give you a good idea as to how much you might lose.
Protective stop losses are an effective tool for managing risk. For example, suppose your trading account is R100 000 and you decide to make two major trades; you may plan to risk only R1,000 on each trade in order to limit your risk to about 2%. On one of these trades, you decide to purchase a stock that often trades between R50 and R51. Your plan is to buy at R50 and sell at R51. How many shares can you buy and still control risk? If you purchased 1000 shares at R50, the price could fall R1 and you would lose R1000. By placing a protective stop at R49, using automatic settings on your trading platform, you will limit your risk to 1%.
More experienced traders may prefer mental stops in which they manually close a trade when it reaches the R49 exit point. The disadvantage of mental stops is that unless one has unfailing discipline, a mental stop may not be executed at the right time. If not executed, the price may fall R3, for example, and when the loss is compounded to R3,000, it may be difficult to fight the temptation to deny the loss and leave it on paper. But losses left on paper may mount further over time, if the trend has completely turned around, and create even more psychological regret and denial. Automatic settings on your trading platform have advantages.
Another approach to setting protective stops is to base them on the percentage of the price of the stock that is traded. Using our example of a stock that sells for R50; suppose a trader may decide to risk no more than 1%. One percent of R50 is 50 cents, so the protective stop would be placed at R49.50. A third way to approach protective stop losses is to use time. Suppose that you decided to make a swing trade in which you anticipate that the price of a stock will increase from R50 to R51 in two weeks. If the price does not move to the R51 target in two weeks, the trade is closed.When setting protective stop losses, it is vital to never do anything arbitrarily. Always make a detailed trading plan. Study the market action of the vehicle you plan to trade. If you have some understanding of the factors that make the price move, along with the range at which a stock moves, you will be able to make an informed decision as to the profit or loss you may encounter and be able to take the necessary precautions to protect yourself. Preparing for a trade makes all the difference. If you make informed decisions, you will know deep down that you have taken precautions to protect your trading capital. If you know that you can survive the worst-case scenario, you will feel safer and more relaxed. There is no reason to allow fear to paralyse you. As long as you avoid touching a hot stove, you will not get burned.
Your first loss is your best loss
In the book "The Disciplined Trader," Mark Douglas suggests, "Execute your losing trades immediately upon perception that they exist. When losses are predefined and executed without hesitation, there is nothing to consider, weigh, or judge and consequently nothing to tempt yourself with. There will be no threat of allowing yourself the possibility of ultimate disaster."
In the book "The Mind of a Trader," Patrick Arbor, former chairman of the Chicago Board of Trade discusses the adage, "Your first loss is your best loss." Many traders do not follow this advice, however. Why? "A lot of it is measured by pain - pain to the pocketbook, pain to the wallet, pain to the psyche." Although traders may intellectually know that they should take a loss, their ego will not let them take a loss. As Mr. Arbor notes, "it (ego) plays with you, because we all like to think that we are smart and like to have confidence in ourselves." This need to protect our ego does not serve us well in the long run, though. As Mr. Arbor observed in his many years on the floor, "The market is always right. No one is smarter than the market. I have seen people come down to the floor with IQs of 150, PhDs, MBAs from Harvard, and not do well because they think they are smarter than the market." In the end, you have to move with the market rather than try to outsmart it. Once you accept that the market has an upper hand, you can take losses more easily, and then move on to the next winning trade.
How can you learn to take losses?
- First, accept the fact that losses are the norm rather than the exception when trading the markets. It may seem like a downer, but realistically, you should expect to lose when trading the markets. (It really is not all that bad, though. Winning baseball players strike out more times than they hit homeruns, and that is how it works with trading. You have to take a chance, and accept dings to your ego. But in the end, you win enough to make it all worth it.) Once you accept this fact, you will trade more carefree.
- Second, make sure to define your risk before you enter a trade. Define your possible loss, or risk, in comparison to your possible reward, or profit. Once you know that the potential reward outweighs the risk, you will feel more at ease.
- Third, practice exiting your losing trades nonchalantly. You may try to make smaller trades for a while so that the loss will not hurt as much. Once you become more accustomed to small losses, you can take bigger losses more easily.
- Finally, do not take losses personally. Losses have nothing to do with you. Do not let your net worth define your inner worth. Do not put your ego on the line with your money. If you can accept losses and live by the adage, "your first loss is your best loss," you will steadily build up the capital in your trading account, and be one of the few traders who end up as a winner.
Seeking out protection from loss
You must risk money to make money. It is sad, but true. You cannot possibly make profits in the markets unless you put up the money. Many people hate taking risks, especially with their money.
Risk is a part of everyday life, though. We take risks all the time, even when we complete the most mundane tasks, such as driving our children to school or flying home to visit our family for the Christmas holidays. We even take risks while staying home. We can slip in the bathtub, for example. We cannot escape risk but we can take reasonable precautions to protect our interests. When you drive down the street, for example, it is prudent to wear seatbelts and carefully drive at a safe speed. When it comes to trading, it is also vital to have proper protection. Adverse forces may go against your trading plan, and unless you protect yourself, you run the risk of getting hurt, and with trading, that often means substantial hits to your trading account balance.
You must be able to handle risk in order to trade profitably. When we are afraid to take a risk, we shrink back, paralysed and defeated. So what can we do? On any given trade, we can alleviate some of the fear by risking a small percentage of our trading account on a single trade, and taking it "one trade at a time" instead of focusing immediately on the onerous goal of achieving a specific return across the entire series of trades. If you can avoid ever thinking of the long-term goal of huge success, you could probably trade forever without hesitation.
There are other obvious ways to feel protected and safe. For example, you can use a protective stop loss to make sure that you restrict the amount you can lose on any given trade. By looking at the past performance of a share, you can estimate an ideal stop loss point that protects you, but does not allow you to get "stopped out" too early. Perhaps the most important form of protection, though, comes in the form of a well-developed trading plan. If you know specifically when to enter and when to exit, you can execute the plan even while feeling afraid of losses. You can easily follow your plan, freeing up your mind to focus on your immediate experience rather than the long-term consequences of a trading loss. It is also important to anticipate adverse events as part of your trading plan. Make sure that earning reports or a rate hike announcement is not going to ruin your trading plan. Careful and precise planning is the best way to protect your trading account balance.
Just like engaging in a dangerous sport, you feel better when you know that you have some form of protection. Athletes protect themselves with helmets, and airbags and seatbelts protect us as we drive in rush hour traffic. Successful trading also requires adequate protection. Protection not only ensures that you can survive to trade another day, but it also allows you to feel relaxed while you execute and monitor a trade. So protect yourself. If anything can go wrong, it usually does. You do not have to worry, however. If you take precautions, you will survive the inherent setbacks in trading, and end up winning in the long run.
Survive now, prosper later
If you are like most novice traders, you want to win big right now. You cannot wait. Many people are motivated by greed. They dream about great wealth and how wealth can solve all their problems. Many novice traders are drawn to the action. Movies like "Wall Street" and "Trading Places" make trading look exciting and sexy. Unfortunately, most seasoned traders will tell you that winning in the markets is a matter of tediously looking for high probability, low risk setups and trading them. All that a quest for greed and excitement will do is distract you from learning how to master the markets.
It takes time to master the markets. Many seasoned professional traders have blown out their trading accounts more than once. In the book "Market Wizards," by Jack Schwager for example, Michael Marcus described how he wiped out his account balance several times before learning how to make millions trading the markets. Although he faced an unbroken string of losses, he did not give up. As he said to the author Jack Schwager, "I would sometimes think that maybe I ought to stop trading because it was very painful to keep losing. In 'Fiddler on the Roof,' there is a scene where the lead looks up and talks to God. I would look up and say, 'Am I really that stupid?' And I seemed to hear a clear answer saying, 'No, you are not stupid. You just have to keep at it.' So I did."
Trading takes years to learn. You have to take the time to learn to develop an intuitive feel for the markets. You cannot just read books and take classes and think you can learn it all. These activities may be essential prerequisites, but real world experience counts too. As Brandon, a seasoned professional once put it, "Books mainly teach basic techniques and give you basic advice: the trend is your friend, buy double backs, buy breakouts, draw trend lines. But books do not talk about emotional experiences." You are a unique person with your own history with the markets and your own resources. You need to learn what it feels like to lose, or what it feels like to hold a position overnight. You have to learn to gauge your tolerance for risk. There is no one right way to trade. You have to learn what you prefer and develop an approach to trading that suits your talents. All this takes time and patience.
Many novice traders make the mistake, however, of trying to rush things. They make big trades rather than manage risk. Big trades are exciting and satisfy the need to make a lot of money as soon as possible. This approach usually fails, though. Novice traders who make big trades just end up wiping out their account balance before honing their skills.
If you are a novice trader learning to master the markets, it is vital to manage risk so that you can survive. Just like many seasoned traders, you will have many years of prosperous trading. What you must do right now, however, is to survive the learning curve. In addition to managing risks, it is useful to specialise on learning the movements of a few specific shares. Learn to get a feel for support and resistance levels for that share. You should know good buy points and sell points. With practice, you will be an expert on a few shares, and soon your intuitive skills can be applied to a variety of shares. By starting out slow and building your skills over time, you can survive the learning curve and end up a seasoned, prosperous trader.
Cutting emotional strings that bind losses to ego
If you are like most traders, you have worked long and hard to build up trading capital. Putting it on the line, even small amounts at a time, can be difficult. But losses are commonplace in trading, and to maintain your sanity, it is necessary to take losses in stride. Many traders blow losses out of proportion. In the book, "The Mind of the Markets," F. J. Chu notes, "The very common phenomenon of personalizing profits and losses often proves disastrous. The linking of ego or self-worth with profitable and unprofitable decisions transforms what should be a dispassionate financial decision into an emotional decision."
It may be difficult, but the professional trader learns how to take losses nonchalantly. Dan describes how he reacted to a big loss professionally and objectively: "One time I lost virtually everything in one or two days, and a good friend of mine came over. I think I lost four or five hundred thousand Rand or something like that. I told him, 'It is only cash. It is not my life that I lost. I can get it back. It is not the end of the world.' When I lose, I am not losing my house, my car, my credit cards, or my friends. I made a mistake. I am angry that I made a mistake, but the cash has nothing to do with it." It is important for traders to put losses in perspective.
It is also important to avoid elevating the importance of money. In "Reminiscences of a Stock Operator," Larry Livingstone observed that when he set his lifestyle standards too high, he often mounted big losses shortly thereafter. Seasoned traders at the Chicago Mercantile Exchange (CME) have observed that when a trader buys a flashy new sports car, he or she usually ends up cracking under the strain of having to maintain a lifestyle of luxury. Dan suggests taking a frugal approach to financial possessions: "I divorced myself from material items a good 20 years ago. By the time I was 25, I had no desires for material items. I have learned over the years that money is only a substitute for love. Material things, like cars and homes, are just substitutes as well. It just became clearer with self-exploration. In getting clearer, I divorced myself from the emotions of the shares, the emotions associated with money and greed. Money just does not buy you happiness."
When you make a trade, put your money on the line, not your ego. It is hard to fight against the natural human reaction to feel personally hurt when you lose money, but professional traders do it, and so can you. One way to take losses in stride is to trade only with money you can afford to lose, not money you need for basic living expenses. If the loss truly means little to you, you will know you can survive the loss, and this knowledge will allow you to stay calm. But if you just cannot afford to lose, you will have trouble convincing yourself that it does not matter. It does, and you know it. Losses should not hurt. If you control your risk, you can handle losses more easily. If you minimise the amount you risk on any single trade, it would not hurt your trading account balance very much. Finally, do not take losses personally. View a trade as a business transaction. It is not about you or your self-worth. You have self-worth no matter how much you win or lose in the markets. If you remember this fact, you will be able to take losses in stride.
Abandoning risk limits
Winning traders manage risk. Risk management is vital for their survival. But financial risk management does not come naturally for most people. Behavioural economists have shown that people can be extremely undisciplined when it comes to risk control. After a big win, they can become overconfident to the point of exuberantly taking unnecessary risks. And after a big loss, they have a strong desire to recoup their losses. Gaining awareness of these human decision making biases can help you neutralise them, and prevent them from shattering your trading discipline.
In a classic study, behavioural economists Richard Thaler and Eric Johnson asked participants to take two gambles, one after the other, using real money. In the first of the two gambles, participants either won or lost money. The point of the study was to see what people would do in the second gamble. Would they enthusiastically take another risk or would they shrink away, averse to risk?
When participants won on the first gamble, they were willing to take a chance on a second gamble. But participants who did not win on the first gamble refused to make a second bet. Behavioural economists call this finding the "house money effect." When people obtain a windfall, they do not mind losing it. They do not see the money they won as their own and are willing to risk it freely. It is like gambling with the casino's, or house's, money. They think, "It is not my money. It does not matter if I blow it all."
When participants lost money on the first gamble, in contrast, they were not willing to make a bet on the second gamble. It is like when a snake or a spider bites you. Once you have been bitten, you are afraid to get bitten again. You do not take a chance in the future. You are too afraid. People do not want to take a risk when they have a clear image in their mind that they are going to get hurt. Behavioural economists call this phenomenon the "snake bite effect."
When losses are especially great, however, people easily overcome the snake bite effect. There is a strong and pervasive tendency to recoup losses. In the "break-even effect," people are willing to go double-or-nothing to make back what they have lost. They will take especially risky gambles on the chance that they can break even quickly. But riskier bets often mean even bigger losses in the long run.
Managing risk is essential for long term survival. But traders are human, and humans can behave irrationally. Overconfident online investors who have made big wins, for example, tend to over-trade and take riskier trades than are prudent. And when novice traders have a long series of losers, many are tempted to make bigger, riskier trades in the hope of recouping what they have lost. Instead of falling prey to these biases, it is vital to steadfastly manage risk no matter what. Do not let common decision making biases compel you to abandon your risk management plan. Winning traders manage risk. If you can control your impulse to react irrationally and emotionally, you can easily manage risk, and achieve enduring financial success.
Sunk costs in everyday life and in trading
Have you ever put your time and money into a project and received nothing for it. Perhaps it is a classic car you have been meaning to restore that has been sitting in the garage for 10 years, or your grandparents' antique sofa that you put in a storage unit you can find a way to fit it into the décor of your living room. It has sentimental value and you just do not want to part with it. It is worth the R250 a month to keep it in storage, right? Maybe you can give it to your children, but at R250 a month for 10 years? That is R30 000! Is the sentimental value worth it? That is up to you, but for some people, R30 000 is a lot to pay for sentimental value. We can get overly attached to our possessions to the point that we do whatever we can to keep them, rather than just let go of them. This attitude can transfer to the trading realm as well. People can become so overly attached to a share that they act emotionally, as if the share has sentimental value. But shares are not for owning and keeping. Shares are for trading, and making money.
Sunk cost effects are powerful. Our time and energy are precious, and when we devote valuable resources to an activity, in everyday life or a trade, we want to believe we did not squander the few assets we have available. When we make a trade, we want to believe that we made a good decision. A nagging voice in the back of our minds whispers, "Why did you risk resources if you did not think that you could make a decent profit?" Your first inclination is to shout, "I did not." But you may have, and it is all right if you did. When you make a trade that is not working out, do not be afraid to admit it. Do not try to justify your decision.
Everyone makes mistakes, and winning traders make a lot of them on their way to enduring profitability. Do not place more meaning on a trade than necessary. It is just a business deal, and when you do make a poor trading decision, do not be afraid to admit it. Do not be riddled with guilt or regret. Many times, we avoid admitting that we made a poor decision because we are afraid of the emotional consequences. We see ourselves as competent and astute, and when we make a mistake, it can make us feel inept and obtuse. It is easier to try and ignore it, and save face. For example, you can leave a losing trade on paper and hope that market conditions will improve and you will recoup your losses. It is usually better to just face the loss, though. Just accept your limitations, and move on. It can be difficult, but you can make it easier by remembering the motto, "Do not feel bad about feeling bad." So you made a mistake. Make light of it and move on. Rather than react emotionally with guilt or anxiety, it is better to stay objective. When you objectively look at a trade, you will be less afraid to study the consequences in meticulous detail. You will monitor your trades, look honestly at how well you are doing and neutralise the sunk cost effect. The sunk cost effect is powerful. It is the demise of many traders who fruitlessly try to ignore what they did wrong, and in doing so remain stuck and uneasy. But if you find the courage to objectively acknowledge when you were wrong, you can take setbacks in stride, and move on to the trades that make you a winning trader.
Do not let a setback get you down
If you want to become a winning trader, you must be willing to face loss after loss without letting it get you down. Upon facing a loss, our first inclination is to feel disappointed, but how you react emotionally is merely a matter of how you look at matters. If you go in with unrealistically high hopes, you will feel devastated when you encounter a setback. If you expect a setback here and there, however, you will feel at ease and ready to bounce back quickly when you are knocked down. Babe Ruth struck out over 1000 times on his way to setting the homerun record. A top-notch salesperson may make a sale on only one out of ten cold calls. And a winning trader can come out ahead even if the majority of trades executed are losers. It is daunting to think about it, but you may see many more failures than successes on your way to becoming a seasoned, master trader.
Seasoned traders know how to take losses and setbacks in stride. They do not mull over past defeats, or trading losses. They see a setback as an opportunity to hone their skills, grow, and improve. They examine what they did wrong, learn from their mistakes, and view a temporary setback as a launch pad from which to achieve higher future performance. With proper risk management, you can win as few as four trades out of a dozen and still come out ahead. Rather than getting bogged down with self-doubt, regret, and defeat, winning traders use a "loss" as a motivator for change and improvement.
How can you afford to take loss after loss and be happy about it? It is not easy. Obviously, if you are losing big over and over again, you will blow your trading account out quickly, and every loss will make you feel even more discouraged and beaten. To feel safe and at ease, you must believe that you can survive the learning curve. Risk management is vital for your survival. Limit your risk on any single trade. In addition, trade selectively. Only take trade setups where you can potentially make a large profit with relatively little risk. That is still not enough, however. If you do not improve, you will still end up in the red. You must feel that your skills are in constant flux in order to take losses in stride.
Market conditions and your mood can impact your trading performance. If you trade in market conditions where you have trouble making a profit, you will feel stressed out and you will likely choke under the pressure. It is better to trade under conditions where you are comfortable most of the time. Your first priority should be on making enough winning trades to profit overall. Even then, you will still see more losing trades than winners. But once you feel secure that you can make profits, you will be able to explore new territory with little fear. Once you know that you have a basic set of skills, you will be able to take losses in stride. So when you feel beaten, focus on the big picture. As long as you manage risk and continue to improve your skills, you will eventually master the markets. In the context of the big picture, the losses here and there are just part of the learning experience. As long as you achieve profitability in the end, occasional losses are nothing to worry about.
Socially responsible investing (SRI)
In April 2005, "Time" magazine published their list of the world's 100 most influential people. On the list is Amy Domini. She runs the $1.5 billion Domini Equity fund, one of the oldest mutual funds based on social responsibility. In the cutthroat world of investing, she offers a thought provoking, alternative perspective. Here are a few excerpts from an interview with her.
What is a social responsible company?
Ms. Domini believes that many corporations operate under the assumption that profits are the first and only priority; many corporate leaders believe that they should make money at any cost, but adhering to this standard has social consequences. Ms. Domini argues that the company's "fiduciary responsibility will consist of meeting that standard, and they will feel justified to do that by any means. They may feel it is moral to bribe somebody at the accounting standards board to create new accounting standards that may make the company look more profitable. Under that standard, it will be their moral obligation to cheat, bribe, and steal. They will feel it is moral to do whatever they can to make money, regardless of the social costs."What role can investors play?
Ms. Domini pointed out that, "The way you invest builds the world your children and grandchildren will grow up in. You must ask, 'What kind of world do you want them to grow up in?' There are two issues to consider: universal human dignity and ecological sustainability. One should be comfortable as a human being; you would like to avoid needing an armed guard every time you left home or requiring your children to play behind a barbed wire fence. There is also a health aspect as far as the planet goes. It is pretty simple and straightforward, but right now, the corporate culture works against these issues because the standard is to make a profit at all costs, and human dignity costs money. Environmental responsibility costs money."
In the interview, Ms. Domini pointed out that there are advantages to investing in socially responsible companies, in addition to the fact that they address issues of human dignity and ecological sustainability. It is harder to both turn a profit and remain socially responsible. Innovative executives usually run companies that address social and ecological issues. They are on the ball and proactive. And because socially responsible companies are more innovative, they tend to be more profitable over the long run.
According to Ms. Domini, it is possible for companies to be both profitable and socially responsible. As Ms. Domini points out, "One wants to be mindful of the world you want your children to grow up in. One wants to be mindful when investing. The investor has ultimate power. The investor is over weighted in power. He or she has more power than other players at the table and needs to take responsibility for his or her actions."
Taking the plunge
The seasoned trader does not trade all day, every day. Market conditions change and it is wise to stand aside until your trading methods match market conditions. At other times you may be feeling off, and it may be better to watch the market than trade it. Trading is a matter of moving from studying and observing to actively participating. For the novice trader or the trader in a severe slump, jumping in can be scary. Trading outcomes are not a certainty. If we knew we could just put on a trade and take home a sure profit, we could not wait to put on trade after trade. (Indeed, that is why most amateur, online investors overtrade. They are unrealistically optimistic and put on a trade even if it has a poor chance of making a profit.)
Getting actively involved in trading requires resolute implementation of a combination of cognitive and behavioural strategies. On the cognitive side, you must examine your thinking strategies and change them. It is just like jumping into a cold swimming pool. Why do you not just take the plunge? It is because you think you will get hurt. If you are hesitant about putting on trades, it is because you are afraid. You are afraid to lose, to be wrong, and to face your limitations. If you arm yourself with thinking strategies, however, you will be able to muster enough gumption to take the plunge. It is time to follow the sage advice of seasoned traders: Expect to lose. Winning traders take losses in stride and that is what you are going to have to do. Look at your assumptions and change the internal dialogue you have while getting ready to trade. You may think, "If I lose, it will mean I cannot trade." But what you should think is, "A loss is just feedback. It does not mean anything about me. ! I can still learn how to trade. I am not going to set my expectations unrealistically high. I am just going to see what happens, and no matter what happens, I am not going to draw the conclusion that I will never become a seasoned trader. Even if I blow out my trading account, it will be a learning experience. It will be money I spent on tuition to learn how to master the game." Once you are armed with these cognitive strategies, you can face potential losses more easily. Some traders have even found it helpful to write down an upbeat passage, like the one above, and read it over and over before a trade and after a loss to restore a courageous, optimistic outlook.
On the behavioural side of things, it is vital for survival to control risk. Make small trades and wait for high probability setups. There is no such thing as a guaranteed trade. Unless you manage risk, you will surely blow out (especially if you are a novice trader), so you must risk relatively little on a single trade or set of trades. That said, you must bite your lip and take the plunge. If you are afraid to take the plunge, you might consider easing into it. Start out making extremely small practice trades. The trades can be so small that the brokerage commissions on them are more than any possible profit you can make. It is worth the costs. It will get your feet wet. It will take the mystery out of the whole process. People have a natural inclination to believe that a feared or dreaded event is more hurtful than it actually is. We tend to exaggerate the potential harm. Once we jump into the activity, however, we see that it is not so bad. Our worst fears are usually never realised. Once you make a series of small trades successfully, you can increase your position size until you reach a position size consistent with your trading account size. The trick is to take gradual steps. It is like building up physical stamina. Do not try to do too much all at once. Work up to it.
Taking the plunge into trading actively can be scary, but we often think it is easier to avoid fears than face them head on. If you examine the assumptions underlying your fear of losses, and then make actual trades to break out of your imposed psychological shell, you can master the markets and become a seasoned, winning trader.
Accepting and reducing risk
Trading is risky. Depending on your personality, you may be extremely intolerant of risk. Most people avoid risks at all costs. Humans had to make prudent decisions in order to survive and evolve. Even though traders know they must risk money to make money, the natural inclination to avoid risk is powerful. How much risk are you willing to take? There is no right answer. It depends on you. If you are a risk seeker, you may not mind risk. You may actually embrace risk and uncertainty. But if you're like most people, the more risk you can eliminate, the better.
You could avoid risk entirely by putting your money in a savings account, but such an investment would bring relatively little profit. The lure of short-term trading is that you have the potential to make huge profits. The downside is the uncertainty and risk you must accept. The amount of risk you take is still up to you, however. For example, it is more risky to trade markets with excess volatility or very little liquidity, so avoiding them will help you stay calm if you have low risk tolerance. Traditional approaches to risk control can also help, such as having a diverse portfolio. If you trade various shares that have little correlation, you have some insurance that a drop in one share may not automatically coincide with a drop in other shares in your portfolio. But no matter how much you try, you must decide how much risk you are willing to take.
Perhaps the most unnerving aspect of risk in the markets is the fact that it is impossible to know all possible risks up front. Who knows what will happen? There are many events that you just cannot control. For example, a media analyst may talk up or talk down a share that you are trading and it may thwart your trading plan. An unexpected national event may influence the markets in ways that you had not anticipated. And when it comes to selling off a position, you may not get the price you want at the moment you are trying to sell. And then there are more basic problems that hamper your plans, like a computer crash or a DSL line going down. In the end, you must psychologically accept the fact that there are some risks that you cannot control.
You may not be able to completely avoid all possible risks, but you can take steps to reduce risk. For example, by setting a stop loss you can determine how much loss you are willing to take. It may take some skill to know where to place the stop loss so you would not get prematurely "stopped out," but in principle you can reduce your risk by deciding a point where a loss is great enough that you would rather close the trade than continue. You can also reduce risk by avoiding thinly traded shares. Even the most brilliant trading plan will fail if there are not enough buyers and sellers to make it work. Reducing risk can be a matter of choosing the right share. And if you are especially risk averse, you can stand aside until there is a strong bull market. But whatever you decide to do, always remember that you have choices. You can decide how much risk you want to take. By matching the amount of risk you take with your tolerance for risk, you can trade more calmly, and that usually means you will trade more profitably.
Cut your losses
When it comes to trading, it is not whether you win or lose, but how much you make on a winning trade compared to how much you lose on a losing trade. If you can cut your losses and move on, you will survive. It makes sense, logically, but psychologically, many traders have trouble cutting their losses. We hate to lose and we will do anything to avoid losing, even it means denying that we have lost. Some are happy to keep losses on paper to avoid the inevitable feelings of regret that often come with a losing trade. People are risk averse. They often sell off winners too prematurely and keep losers too long, hoping that somehow things will turn around. But it hardly ever works. Many people would be wise to follow the advice of Paul Tudor Jones, “I spend my day trying to make myself as happy and relaxed as I can be. If I have positions going against me, I get right out. If they are going for me, I keep them." It is vital for your long-term survival that you admit that you have made a losing trade, and close it out.
Humans have a natural inclination to avoid losses, but seasoned, profitable traders cut their losses early. They work under the assumption that they will see many more losing trades than winning trades. Knowing how to take a loss in stride is a key skill that all traders must develop. It is often easier said than done, though. Behavioural economists have outlined many psychological processes that prevent most traders from accepting a loss and moving on.
First, humans are naturally risk averse. They do not like taking losses. When it comes to sure win they take it immediately. But when it comes to a sure loss, they would rather take a chance, hope for no loss at all, and possibly take a huge loss, than just take a small loss up front. Both professionals and amateurs can fall prey to this tendency. Trading lore is replete with tales of traders who just could not take a small loss immediately. They hold on to losses rather than admit they made a big mistake. The losses continue to mount and the hole gets deeper and deeper. The human mind has a remarkable capacity to ignore what it does not want to see. And losses are hard to see.
Second, a major psychological reason for holding on to a losing trade is the sunk cost effect. The more financial and psychological costs we sink into a trade, the harder it is to take the loss and move on. It is like thinking, “I have waited so long and I have lost so much of my initial stake that I cannot give up now." There is a strong need to justify the effort and expense you have put into holding a losing position. The psychological need to justify the loss is so great that it can be difficult to write it off.
Third, social processes prevent many traders from taking a loss. It is hard for some traders to keep their wins and losses to themselves. Trading can be a lonely profession, and it is useful to join a network of friends to share experiences and get support. The downside, however, is that some people in the network may compete with you, just waiting for you to have a setback so that they can feel superior. You may look forward to relishing your wins, but dread having to admit your losses. The need to save face can prevent some traders from taking a loss. The best antidote to this problem is to stay humble. Do not brag about your wins. If you avoid getting a swelled head, you will be able to admit your mistakes and shortcomings more easily, and you would not worry about becoming embarrassed for losing.
Cutting your losses is vital for success, but it is hard to do. Be aware of the powerful psychological factors that prevent you from taking a loss and moving on. It may be hard to do, but if you work under the assumptions that losses are inevitable, and do not take losses personally, you will be able to cut your losses, move on, and make huge profits.