From the January 01, 2008 issue of Futures Magazine • Subscribe!

Avoiding common trading pitfalls

Trading is Darwinian. If you evolve the qualities needed to trade profitably consistently, then you survive. If you do not evolve these qualities, you become extinct. The fittest thrive.

When I began my journey to trading full-time, an opportunity to speak with an exceptionally successful investor presented itself. We talked about several aspects of trading, including the differences between long-term investing (his approach) and short-term trading (my approach), but it was one of his questions that was most enlightening.

“How do you feel when you make a good trade?” he asked. I’d never thought of this before, and although my answer was truthful, it was surprising: “When I make a good trade, I feel nothing.” He said that was good. While we talked for some time longer, the realization that emotions have no place in trading, win or lose, was the most valuable lesson from our conversation.

No matter how well you know how to trade — you may have memorized the greatest trading strategy ever devised — if you don’t keep your emotions in check, you will never be successful. Of course, no one can completely escape their emotions, but we can understand and practice what it means to “feel nothing.”

TRADING PITFALLS

Regardless of your trading style, technique, time frame or market, there are a number of common traits that can trip you up. Not all underperforming trades can be traced to the following reasons, but in the absence of simply a bad trading technique, many can:

The tendency to trade impulsively.

The tendency to miss an entry point, then enter too late.

The tendency to deny a losing position.

The tendency to enter a bad period of trading immediately after a good period.

Frequently, these pitfalls result in a condition known as the ugly trader syndrome. It describes the ability of a trader to trade just fine — to a point. At that point, seemingly inexplicable forces intervene to prevent his account from growing further. This is often defined by a specific dollar amount.

No matter how much the trader wins, he loses the gains in a frustrating win/lose cycle. Or the trader loses a chunk of money, makes a partial comeback then finds a new, lower dollar level blocking any advance.

However, there’s no mysterious force behind this cycle. The trader is at the root of this, and it’s up to the trader to admit that he is the source of it. The first step in avoiding these common trading pitfalls is to accept that you are the cause. And the reason why is at the heart of the human condition: emotion.

LUCKY OR GOOD

You know the feeling. You’re happy when you win. You feel excited, relieved, maybe even bored or exhausted. Consider these one by one. If you feel happy and excited, the psychological translation may be that you are trading to be happy or excited. The downside of this is more apparent when you consider what happens when you make a bad trade. You can be tempted to ignore the bad trade because you don’t want to be denied happiness and excitement. Ignore enough bad trades and you go broke. Game over.

You feel powerful when you are happy and excited. While we generally view happiness as a good thing, what’s wrong with it relative to trading is that we have no power over the markets. Feeling powerful can lead you to assume that any trading decision you make will be right, that you do have power over the markets. A bad trade does not fit with a sense of power. You may try to use your sense of power to wish a bad trade away. Ignoring bad trades is expensive.

What’s wrong about feeling relieved when you make a good trade is that by doing so you equate the act of making trading decisions to a mental pressure that you want to release — in other words, avoid. You can’t expect to become good at trading if you try to escape decisions.

Sometimes, you can become bored after making a good trade. This is normal. Trading can be an emotional roller coaster. You can swing between enthusiasm and depression, and boredom is a stop on the way. You escape from the swings by seeking a disassociated mental state.

Exhaustion is another common result from a good trade. A trading decision has real consequences. You make or lose real money, and that can be stressful. The indicators involved in making a decision can be confusing. Applying them correctly can require an enormous amount of willpower. This adds stress. You might sometimes find yourself coming up with reasons to avoid trading, simply to bypass the stress and exhaustion that can result from a trade, good or bad. You trade smaller positions. You sideline yourself more often. It’s OK to take a break when you do it consciously to regain focus and get back in the game. It’s not OK when you do it subconsciously. Exhaustion, boredom, relief, excitement and happiness are all warning signs that you are trading emotionally.

SOLVING THE PROBLEMS

When we talk about trading mistakes and emotional trading, it is usually code for failing to have discipline. Staying disciplined is tougher for discretionary traders who are not locked into a system with definitive rules. But even discretionary traders can create rules for how they execute trades and the parameters they use in determining an entry. It is important to remember that the best systems and traders experience losses. Every trade, win or lose, needs to be evaluated. We can be fooled into believing the problem is with our losing trades when it may be with failing to properly exploit our winners. To avoid these pitfalls, your goal should be to eliminate emotions from your trading. You must learn to appreciate the value of feeling nothing while you trade.

Trading impulsively is one of the most common pitfalls. You know intellectually that you should wait for a sharp run, a clear turning point or a clear trend, but for whatever reason, you don’t wait. For example, you try to pick the bottom and by doing so, you put the odds against you. The result is you suffer an immediate loss, a choppy pattern of losses and gains or at best a minimal gain.

When you feel pressure to trade for the sake of trading, learn to be patient. Accept that opportunities always come along. Remind yourself to wait for a clear opportunity. This conserves energy. Decision-making will not be exhausting. Your interest level will remain high as you scan for the next opportunity. You will not look for relief, excitement or happiness. If you have a tendency to miss a good entry point, work on identifying entries earlier, do not enter a trade hoping your last parameter will be met. Decide or stand aside.

If you do not train yourself to recognize a good entry point and act fast, then you can end up holding the bag. Yes, you can also enter too soon and be just as wrong, but there is a line between an instinctive trader (or at least a well-trained trader) and a trader frozen by his own indecisiveness. A frozen trader keeps catching the tail end of good trades.

The inability to act is one reason why many traders do not follow their own trading system. They do not trust themselves or their system. The solution here is know your system’s entry logic — not just what gets you into a trade but how the market tends to act around an entry point. Study old trades and learn to enter good trades sooner. If you deny losing positions, train yourself to believe that denial is bad for traders. Do not rationalize losses. Shock is different than denial. Shock sets in immediately after a bad trade or a mistake and is temporarily beyond your control. But when the shock wears off, you have an opportunity to regain positive control. You must admit the trade and exit or you will lapse into denial, which can be much longer lasting. Understand how denial and shock work. Admit that shock can and will happen and learn to bounce back quickly. If you have a tendency to enter a drawdown immediately following profitable periods, look at trading as work. Trading is a unique collision zone between people who know it is work and people who assume it is impossible or easy. Occasionally, academics will insist it is impossible to select and time winning trades or that buy-and-hold strategies and random darts are as good as human analysis. These commentators ignore successful traders — the money managers, pit traders, investors and day-traders who have made a career out of taking other people’s money using the markets. But in some ways, they are correct. Bad can frequently follow good, giving the impression of randomness to an otherwise solid strategy. Often, though, this return to the mean can be attributable to emotional trading rather than randomness. Just like a worker in any other profession, traders are at risk of wanting to work less, to be less disciplined. In a word: lazy. We are typically at a greater risk of falling into this trap just after we’ve performed our strongest.

If you are doing well, do not recklessly speed up or get lazy. Keep your mind clear and centered during the good times. A tick, or several tick, loss on a winning trade is just as costly as that tick loss on a losing trade. Too many traders blow out because they spiral downward to the point where they are mentally and financially hollow. They have no reserves to help them rally. Don’t fall that far. Think how many successful, even legendary, traders failed mightily before they sprang or clawed their way back. These traders had a last ditch defense. Think of it as the safety in football or the backstop in baseball. You need something watching your back. Consider these techniques. First, scale back your size. If you can financially handle “x” contracts or shares then restrict yourself to “x minus y” contracts. That way, even if you take repeated hits, you won’t sink. If you are determined to make one of the common trading mistakes, then, in this case, delay. Delay, trade small and go to cash as soon as you can summon the willpower.

Trading can be an expensive process. A lot of failed species lie in the wake of Darwin’s process of natural selection. That’s also true for traders who were unable to keep their emotions in check. Learn to control your emotions before they lead you down the wrong evolutionary path. If more would approach the mental side of trading with the same methodical approach that they tackle their strategy rules, they would more quickly evolve into better, less emotional, traders.

Richard L. Muehlberg uses linear regression channels and intermarket analysis to day trade his own account. He publishes a day trading diary on his site: www.DayTradingWithLinesInTheSky.com. E-mail: richardmue@yahoo.com.

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