Tuesday, August 04, 2009

Overtrading and Our Unrealistic Expectations

Many, many times, overtrading a market (i.e., placing trades when you lack an objective edge in the trade) begins with unrealistic expectations of the market.

The most common mistake I see active traders making in the current market is that they are expecting moves to extend much more than they actually end up extending. In short, they are not factoring current volatility into their expectations.

"I think we could go way above 1000," a trader told me yesterday. His scenario was that the round number would bring lots of bulls late to the party into the market in a panicky rush. Maybe that will happen over time, but his scenario called for stocks to move 3% or more on an open-to-close basis. How many times has that occurred in the last two months? Just once.

Not exactly a scenario to hang your hat on.

When you find yourself anticipating a big market move, ask yourself whether the market is actually moving in that way, or whether you are simply hoping for such a move. The average volatility (average high-low daily trading range) for the S&P 500 Index (see above) is less than one-third what it was earlier in the year. In the last 10 trading days, only one has moved more than 2% intraday. In January and February we saw a number of ten-day periods in which *every* day had a range of more than 2%.

If a move isn't going to extend, it will reverse.

That means being proactive in booking profits when ranges are small.

It also means that placing many trades to catch a big move is a great way to get chopped up and lose money.

Smart trading begins with realistic expectations.

For more, check out posts on Learning When to Not Trade and Pressing Too Hard to Win.