Learned the Hard Way November 25, 2008

Some advice for traders from Deron Wagner this morning:

For those new to trading and/or this newsletter, the concept of staying mostly in cash, and taking a few shots here and there with reduced share size, is tough to grasp. Many new traders are anxious to test out new strategies/methods, and have expectations of outperforming the market every single month. But we’ve learned the hard way, through years of experience, that knowing when to go full throttle, and when to apply the brakes, is the key to long-term success as a trader. Capital preservation during indecisive and erratic market conditions enables us to be in the game for the long-term, so that we can aggressively take advantage of opportunities when the good times return.

Preserving Psychological Capital November 10, 2008

The psychology of trading cannot be ignored.

Some good stuff today from Janice Dorn, “The Trading Doctor” – you should go ahead and read the whole thing:

Estimates are that 75-95% of all traders lose all their trading capital in the first year, and only about 5-10% of those that get into trading are able to stay profitable on a consistent basis after 5 years. This is not encouraging. However, since the majority of people tend to be overconfident, most believe that they are not going to be among the casualties.

What is behind this overconfidence?

Some of the most highly educated professionals such as doctors, lawyers and engineers who are used to being first in their class–the best of breed in whatever they do– fail miserably as traders and investors. The reason is that the process of trading and investing is completely different from activities and ways of thinking that bring success outside of the markets. Trading is a counterintuitive to what we are taught growing up. As we grow and develop, we acquire levels of control. We learn to control our bodies, movements, environments, who we chose as friends, lovers and mates, our educational goals, where and how we live. We get cozy and comfortable in our little worlds where we make the rules, and live out our lives in accord with them. Yes, there is a lot going on in the world, but it really doesn’t mean all that much unless it affects us directly. When external challenges face us in our personal lives, we take control, problem solve, and get done what needs to be done.

In the markets things are quite different. There is no way to control the market forces. Markets are larger than life, yet they are life. Millions of people from every part of the world are there making decisions that affect you in either a positive or a negative fashion. Millions of nameless and faceless people are trying to take your money before you take theirs. There is no situation in the life of most people that compares with this. That is why successful trading and investing requires one to adopt an entirely new brain-set.

The majority of people are simply not neurologically flexible enough adapt to this new environment. They insist on adapting the markets to their own worldview, and they fail—sometimes miserably so.

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Small losses almost always become larger and larger losses, leading to every manner of emotional distress as you are holding and hoping, or in complete denial that the position could possibly turn against you. Holding and hoping leads to larger losses and more emotional carnage until you are a financial and neuropsychiatric basket case and you just want out at any cost. Desperation, anxiety or depression set in and remind you of every time in your life you were told that you were not good enough, that you would never amount to anything or that you didn’t deserve to win or be successful. You are now in a state where both financial and psychological capital are depleted–all because you didn’t take a small loss.

How do you preserve your financial and psychological capital? You learn to embrace risk by using rigorous risk management techniques. The most important of these are position sizing, stops and money management. You take small losses. You take small losses! You let winning positions run and take profits and trail stops as they are running. Please memorize this until it is burned into the connections in your brain: The single biggest reason for failure as a trader or investor is the inability to take small losses and letting them grow into larger losses.

It's An Art November 5, 2008

Knowing where to place your trading stops is more of a art than a science.

From “The Art of Protective Stops” (pdf file), by Dave Landry:

In an ideal world, a tight stop could be placed right below the low of the pullback (as inferred above). Unfortunately, very seldom does a market do exactly as we desire. Markets often continue in the obvious direction but not without trading back and forth first. Therefore, a tight stop would likely be hit on this normal “noise” alone.

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…stops are a bit of a science and a bit of an art. There’s no precise area they should be placed. As illustrated above, tight stops help to mitigate large losses but they almost guarantee that you will lose (on virtually every trade) since they are likely to get hit on noise (normal market fluctuations) alone. This can be frustrating as you watch a market that you were just in, take off without you.

Loose stops help to ensure you stay in a market long enough to capture a resumption of the trend. However, when the trend does not resume, the losses are too large.