Source: Stockscores.com Perspectives for the week ending January 28, 2013
This week’s Trading Lesson
Stock traders go through many different phases in their quest to be a master of the market. Initially, the focus is on learning how to pick good stocks to buy or short sell. Countless books may be read, classes attended, computer software purchased or websites used in this quest to get the entry decision right. However, even those that can master the entry decision are not usually successful in the long term. Too much emphasis is placed on the entry decision.
Suppose you were a great stock picker and were able to pick stock trades that were profitable 90% of the time. Does that mean you will make money? Most people would think that it would because they fail to understand what is really important about trading successfully.
If 90% of your trades make you $100 and 10% of your trades lose you $1000, do you make a profit over a large number of trades? Some quick math shows that after 10 trades, you are losing $100 despite being right most of the time. In school you would get an A grade, in the trading, you have earned an F.
The key is to focus on how much you make when you are right versus how much you lose when you are wrong. A trader that is right 50% of the time, making $500 each time they are right but then only losing $100 the other 50% of the time makes $2000 every 10 trades. Not bad for a barely passing grade of 50%.
After a person learns to pick the right trades, this concept of reward for risk and expected value is the next big realization in the quest to become a successful trader. However, understanding this second phase of learning does still not assure the trader of success. The final phase is the most difficult to master.
Having the emotional mastery to have patience with your profits and no patience with your losers is the final step. While it seems easy to say that you have to follow your trading plan, actually doing so is much more difficult. The emotional attachment that most of us have to money is what makes it difficult to follow our rules. You can be a great stock picker, do well at managing risk and still not succeed as a trader if you fail at emotional mastery.
To achieve the final step, you must take the focus off of the money. The financial risk has to be taken out of the decision making process allowing you to apply the analysis techniques you developed in Phase 1 with the risk management techniques in Phase 2 without any emotional bias. Easy to say but hard to do, here are some techniques to help you achieve emotionless trading.
1. Don’t take more risk than you can tolerate – taking too much risk is the most common reason traders hang on to their losers and sell their winners too early. Taking too much risk attaches an anchor to your risk management techniques, hindering your ability to have a positive expected value on your trades.
You can change this by lowering the amount of risk that you take but many traders then find that there is not enough upside to motivate them to trade at all. Without a way to make good profits for the capital that you have, the trader may start to take on more risk as a way to chase performance.
However, you can increase the upside potential of your trades without adding more risk by scaling in to your positions. If you add to your winners as the trade is working in your favor, you increase the upside potential. However, you don’t have to take on added risk by doing this because you can use the profit of your initial positions to mitigate the risk of your additional positions. Add to your winners, never add to your losers.
2. Change your financial focus – I often advise that it is best not to look at the profit and loss summary for your trades. Doing so causes you to get wrapped up in the current gain or loss on your positions, heightening the fear or greed that you feel about the trade. Instead of making decisions based on the chart, you make decisions based on the financials.
I am not sure it is realistic for people to not check their trades and know whether they are making or losing money. Therefore, if you have to look at your trades, rather than focus on the current profit or loss, consider what you will make or lose if your trade is stopped out.
If you buy 1000 shares of a stock at $10 and the stop is at $9, you stand to lose $1000 even if the stock is trading at $10.25. That is the loss exposure you have at the exit door.
Suppose that this stock rises up to $12 and you move you stop up to $11. While your position is currently up $2000, if you get out on the stop you are actually only going to make $1000. You have to put your focus on the number that coincides with your exit point, not where you are at now.
If you think, “Hey, I am up $2000 on this trade!” and you start to attach your emotions to this number, you are going to be more likely to not exit if the stock falls back to $11, where you only make $1000. You had expectations for a $2000 profit, hoping it would go higher. Exiting at a lower price is painful and many people hang on, hoping for a turnaround.
Count on what you have, not what you are hoping for.
3. Write down a plan and trade it – the emotion of a trade can cause some mental breakdown in the execution of the trade because your emotion causes you to stray from your trading rules. Having a written plan to go to during confusion will help you stay on track.
The plan does not have to be long or sophisticated. I don’t think that a trading plan should be more than one page. In it, you should have your rules for entry, risk management, scaling and exit. There should also be a process of review so that you are constantly working to improve your rules and the execution of your rules.
Ideas have a greater value when you write them down, take the time to draft a trading plan before you make another trade.