This Week’s Trading Lesson
I have often said that making money trading stocks is simple, but not easy. Once you learn basic technical analysis techniques, have good tools to identify opportunities and gain some experience at identifying good trading opportunities, the actual job of picking stocks is relatively straightforward. Where most traders fail is in the application of a methodology. The simple and undeniable fact is that we are all human, and therefore, we are all blessed with emotion. When money is on the line, our emotional attachment to it can take over our decision making process.
With that said, I thought it would be helpful to examine the common problem areas that are a result of mental breakdowns. By examining the emotional conduits to decision making, hopefully I can provide some solutions to correct common trading mistakes.
Trading Problem #1 – No Patience on Entry
Anticipating a signal that never comes is common for traders monitoring the market closely and eager to get some money working. For example, a good buying opportunity arises when a stock breaks from an ascending triangle. Jumping in ahead of the breakout is not an ideal situation because the probability of success buying an ascending triangle is not as good as buying a breakout from one.
What causes this mistake? I think a fear of missing out on the maximum amount of profit or the fear of too much risk in buying a stock are the two most common mistakes. Essentially, the two guiding forces of the stock market are at work here; fear and greed.
By buying early, we can realize a greater profit when the stock does breakout since we will have a lower average cost. Or, by buying early we can reduce risk since a breakout followed by a pull back through our stop will result in a smaller loss as we have a lower average cost.
What tends to happen, however, is that the stock does not break out when expected and instead pulls back. This either leads to an unnecessary loss or an opportunity cost of the capital being tied up while other opportunities arise.
The Solution
The simple and obvious solution is to wait for the entry signal, but there are also some things you can do to help yourself stay disciplined. Rather than watch potentially good stocks tick by tick, use an alarm feature to alert you to when they actually make the break. Watching stocks constantly is somewhat hypnotic, and I think the charts can talk you in to making a trade. However, letting the computer watch the stock may help you avoid the stock’s evil trance.
Another good solution is to focus on different thoughts when considering a stock. Don’t think about potential profits, don’t think about minimizing losses. Instead, focus in on the desire to execute high probability trades. It takes time to reprogram yourself, so persevere.
Trading Problem #2 – Selling Too Soon
We have all felt the disappointment of not selling a stock at the high. When a stock is marching higher, we set a point where we intend to sell so that we can lock in the gain before it goes down. The problem is that after we sell the stock, it continues to go higher leaving us with an opportunity missed.
Selling too soon is a problem that I continue to wrestle with after 23 years of trading stocks. I want to lock in that good feeling of taking a profit off the table. I want to avoid the negative feeling of watching a good profit get cut in half by a rapid sell off. And so, I break my selling rules and sell the stock in anticipation of weakness, rather than when the market tells me I should.
The result is that profitability over the long term is not maximized. Once in a while, I may get out of a trade at a better price than I would if I followed my rules, but over 10 or more trades, my net profitability is not as good as if I had maintained my selling rules. Keeping in mind that trading stocks is a probability game, it is important to maximize gains on the winners so that the inevitable losers can be overcome.
The Solution
There are few things that can help you avoid falling in to this trap. First, go through a number of past trades and apply your selling rules to see what your net profitability would have been if you have been disciplined, and compare those with what you actually achieved. I did this and it gave me powerful proof that maintaining discipline pays off, and is worth striving for. In fact, when I did this over one particular one week period, the difference amounted to a pretty nice new car! That gave me the leverage on my emotions I need to overcome them.
Second, turn off the profit and loss indicator that most brokerages and trading platforms give you. How much you are up or down is irrelevant to the decision making process. Since we have an emotional attachment to the money, knowing that we are up a certain amount and then seeing that shrink on a normal pull back in a stock leads us to make an emotional decision.
Finally, remember to sell at floors, not ceilings. Do not limit the upside movement of a stock by setting a price target, but instead, limit the downside movement by setting a price floor. Sell a stock when it pulls back to a floor, rather than selling it in anticipation of it reaching a ceiling price.
Trading Problem #3 – Letting Small Losses Turn in to Big Losses
As I just mentioned, trading stocks is a probability game. You will not be right all the time, which means that one of the most important aspects of trading stocks is to never let small losses grow in to big, portfolio debilitating losses. You have to limit losses at a risk level if you are going to be successful over the long run.
Solution
The simplest and I think most effective solution for most people is to set a stop loss point before purchasing a stock, and apply it immediately after purchasing a stock. Use basic chart analysis to determine where the market will have proven your decision to enter a trade wrong, and set your stop just below that. Automated stop losses are best because they do not require you to have the discipline to pull the exit button. Do not change your stop once you are in the trade. Making the stop loss judgment before you enter the trade is best since you will not have an emotional attachment to the stock at that point since you have not put your money on the line yet.
Trading Problem #4 – Trading Low Probability Opportunities
My dad is one of those do it yourself guys who would rather work hard than have someone else do the job for him. As a kid growing up, that meant that I helped build fences, garages, basement developments, pour concrete driveways, do yardwork and generally learn that same ethic to work hard. I am thankful that I have that spirit, but in the early stages of being a trader, it was something that hurt me.
The stock market cannot be made to go your way by hard work. There are times when the market giveth, and there are times when the market taketh away. The legendary Vancouver stock promoter Murray Pezim once said that all abnormal profits in the stock market are just short term loans. His point is that people do not know when to leave the market alone, and when it is time to work hard.
Traders will tend to take low probability trading opportunities at the worst time, because it is during weak market conditions that the market only shows marginal opportunities. By working really hard, traders can find opportunities that are pretty good, but not great. By taking these lower probability trades, the trader sets him or herself up for failure, since their rate of success will not be as good.
The Solution
I have said it many times, when the going gets tough, tough traders get lazy. You must always be picky about the kind of trades you make, particularly when the market is weak. Working hard to find opportunities will not make you more money, working hard at being disciplined will.
Teach yourself to look forward to the slow times. Make a list of things that you are going to do when the market slows down. Plant a tree, play golf, kill the ants that are crawling around your house. Just make the list.
Perhaps most importantly, if you depend on the market for a paycheck, make sure that you bank money when the market is good so that you don’t have to trade when the market slows down. Making a trade because you need to pay some bills is not a good way to trade.
Trading Problem #5 – Overtrading
There are stock traders who make 150 or more trades in a single day. I am not sure they make a lot of money. I firmly believe that you can make more money by making fewer trades because it will make you focus on only the best of opportunities, and play them with a larger amount of capital so the pay off is better. By being patient and disciplined with the really high probability trades, you can maximize profitability.
The Solution
If you are currently making 50 trades a week, tell yourself that next week you will only be allowed to make 10. If you are making 20 a week, promise yourself that you can only make 5. Don’t just tell yourself that you are going to stick to your new rule, write it down!
By setting this limit, you will hopefully change your outlook and try harder to only consider very high probability trades. We want to focus on great trading opportunities, not just those that are good.
Trading Problem #6 – Hesitation
You are watching a stock that has all the signals you look for in an opportunity. The proper point to enter comes, but you wait. You second guess the opportunity and don’t buy the stock. Or, you bid for the stock at a price that is not likely to get filled if the opportunity does pan out the way you anticipate it will. As a result, you get left behind while the market pushes the stock higher.
A short while after the initial entry signal, when the stock has made a decent gain, you decide to finally enter the trade. After all, the market has proven your analysis correct, so you must be smart, and right! Not long after you enter, the stock turns south and you end up with a losing trade. If only you had bought when you first thought about it.
The Solution
This is really just a confidence issue. You are either not confident in your ability to analyze stocks, or you are not confident in the methodology that you are using to pick trades. Therefore, you have to research your method so that you have the confidence that it works. Then, you have to start small, making trades that have a potential loss that you are comfortable with. As you gain confidence in your method and your ability, increase the trade size. With your new found confidence, stand in a crowded room and scream, “I am great!” Well, maybe don’t carry it that far.
Trading Problem #7 – Letting Winners Turn in to Losers
The final trading problem that I want to focus on is allowing winning trades to turn in to losers. Many of us have probably had a time when a trade was making big loot, and we started to count the profits like they were ours before we exited the trade. When the stock started to lose the ground it had gained, we avoided selling because we had built up an emotional attachment to the paper profits we had seen. Instead of selling the stock to lock in some gain, we opted to hold out for the stock to go back to where it used to be, promising to sell when it came back to the point where we felt good about the trade. The stock drifts lower, and eventually the gain turns in to a loss. We ultimately sell it at the bottom, swearing never to do it again. But without some reprogramming, we probably will.
The Solution
Like Kenny Rogers used to sing, “Don’t count your money, when you are sitting at the table, there will be time enough for counting, when the dealing’s done.” Do not calculate your profits before you lock them in. Avoiding the profit watch will help you avoid an emotional attachment to the paper profits, giving you greater clarity to take the exit door when the market tells you it is time to do so.
I hope this outline of mental problems and some solutions helps you become a better trader. The difference between those who succeed in trading and those who fail is not the system they play, but how well they play it. Your mind is a powerful thing, don’t let it beat you in the market.
Source: Stockscores.com Perspectives for the week ending April 1, 2013