Thursday, October 30, 2014

Two of the Biggest Mistakes Traders Make

As I look across the good trading and not-so-good trading that I've observed over the years--my own, as well as that of others--there are two big mistakes that stand out as key differentiators:

1)  Putting Prediction Ahead of Understanding - In a sense, this boils down to acting before we truly understand the rationale for action.  At first blush this makes no sense at all.  Still, the fear of missing moves and the need to make money sometimes lead us to anticipate market behavior before we've fully done the work of understanding why markets should move in such a fashion.  Traders often speak about the importance of having confidence in their views.  Genuine conviction, I find, is a function of deep understanding.  If we perceive that we have a grasp of what is driving markets, we are more likely to stick with the trade ideas emanating from that understanding.  Nothing guarantees, of course, that our explanations of market behavior are correct.  It's a pretty good guarantee, however, that if we anticipate market movement and put on positions before we achieve a grasp of why that movement should occur, we'll be easily shaken from our ungrounded convictions.

In the chart above, I track what I call "Demand" for stocks.  It is a running five-day average of upticks vs. downticks among NYSE shares.  There is some predictive value to those data, but particularly important from my vantage point is putting the data into context to understand what is happening in markets.  When markets move quickly from a point of negative Demand--net selling pressure--to a point of high Demand (net buying pressure), that momentum reflects an important shift in market participation that tends to persist over the near term.  Conversely, when markets bounce higher but net Demand remains negative, that suggests a lack of upside participation and, ultimately, a vulnerability to the rise.  Note how that was the case during the market topping in September.  One important component of understanding is simply identifying whether buyers or sellers are in control of the market and which way that balance is moving.  Identical chart patterns can follow from very different configurations of net Demand.

2)  Mismatch of Time Horizons - This is the result of conceptualizing trade ideas on one time horizon and managing the risk on a very different time frame.  A classic example would be a "macro" trader who develops a fundamental thesis about how stocks should move over the next 3-6 months, but then is forced to stop out of positions on retracements that, ultimately, are expectable over such a time period.  In other words, the psychological tolerance for loss is poorly matched with the trader's conceptual framework.  This occurs at trading firms where risk is managed tightly, but where traders still feel a need to stick with ideas and maintain their convictions.  I recall working with a rookie daytrader whose hit rate on trades was startlingly abysmal.  It seemed as though the results were not random, but represented a significant negative alpha.  What that trader would do is set stops insanely close to the point of entry, pride himself on a "good risk-reward trade" and then get stopped out 80% of the time on a putative 3:1 good bet. 

When the press for opportunity greatly exceeds the tolerance for loss, it's a sure bet that good trades will be managed poorly.  We can have superior market understanding, derive excellent trade ideas from that understanding, and still fail to make money simply because we our psychological misalignment between risk and reward leads to poorly aligned position management.  Far better to stay in good trades with modest size than continually stop oneself out on noise and fail to capitalize on solid understanding.

Further Reading:  Five Distinguishing Features of Great Traders