Saturday, August 04, 2007

Painful Truths About Trading

The markets have been exceedingly volatile, and that has created pain as well as opportunity for traders. Here is a portion of an unusually perceptive email to me from a reader:

I have to trade conservatively since I am still in the beginning stages of the trading process…I trade a miniscule amount of shares. (I used to trade a large number in the beginning, which was not a smart thing to do, needless to say). But for now…I am trying to be as careful as possible...

When I enter a trade (upon breakout)…, I know exactly where to put my stop, so I know the exact amount I am willing to lose (less slippage). It usually…rallies a little bit, then pulls back, many times even below my entry point.

So far lately, I have taken the very tiny profit as it rallies a little after the breakout and then I quickly get out with a market order (...just because I have been burnt so much in the past - so I am being neurotically cautious to my detriment perhaps, since I could have so much more by staying in the trade). But then often the stock will rally back up and up and up ...without me on board....

So, then I get in again at the next breakout point and I am nickel and diming myself to wealth (to achieve wealth this way could take the next thousand years)....

Would it be actually smarter for me to just set my stop loss...but IF it does not retreat that far back, then, after it definitely cleared my entry point, just move my STOP LOSS to break-even (or arrange trailing stops) and go to find another trading opportunity?

There is so much pain involved in trading....

The reader is well aware that these trading patterns will not bring success. The question is how to address them. Here are a few considerations from both a trading psychology perspective and a pure trading one:

1) End the Pain - If you were experiencing significant spinal pain every time you walked, I would tell you to stop walking and call for help. Pain is a warning signal, and that includes emotional pain. A key to our trader's post is that he used to trade larger, but no longer because, "I have been burnt so much in the past." It is the retriggering of those losses that is contributing to his sense that "there is so much pain involved in trading." This is the dynamic of traumatic stress: events in the present flash us back to the painful events of the past, and we relive many of those emotions. While we may not be able to resolve traumatic stresses immediately, we certainly can stop restimulating them. Above all else, do no harm. Stop trading. Totally. Learn some behavioral methods of controlling anxiety and frustration and practice these daily (meditation is a great skill in this regard; combining biofeedback with deep breathing and guided imagery can also be effective). Once you master these methods, make yourself relive your prior trading losses *while you perform the meditation or relaxation exercises*. Keep repeating that until you get to the point where you can vividly visualize and reexperience your past trading losses without getting physiologically worked up. This is far and away the most effective approach to reprogramming traumatic memories. A therapist trained in behavioral methods (exposure work) can assist you with this work; it's not necessary that the person be a "trading coach" or know anything about trading.

2) Re-create Safety - Once you've made significant strides in reprogramming your emotional experience, go into simulation mode and rehearse proper trading strategies (see below) while keeping yourself calm. Only when you can implement your strategies *consistently* and with a calm focus should you consider going live with small positions. Then make yourself achieve consistency and calm with small positions before you gradually raise your size. The only way to overcome trauma is to experience repeated safety. The worst thing you can do is get frustrated and try to make your money back all at once, risking further emotional injury.

3) Research, Research, Research - If you're trading breakout patterns, study every breakout and false breakout you can find to become sensitive to the differences between the two. Look at volume on breakout moves; study normal retracements of valid breakouts vs. the more significant and rapid retracements of false breakouts. Examine behavior of indicators such as NYSE TICK on breakout moves. Your trading approach should reflect your research. Study the "tells" that occur prior to the big volume moves: selling (negative TICK) that cannot move the market to relative lows or buying (positive TICK) that fails to push the market meaningfully higher. Work on entering the long side on those TICK pullbacks; the short side on the TICK bounces. That little execution edge adds up over time. It also provides a natural stop point for short-term traders if the market initially goes your way and then reverses.

4) Practice Hitting Targets - What's missing from our trader's email? Profit targets! We hear a lot about stop loss and pain, not much about profit targets. In the absence of such targets, it's easy to get caught up in tick-by-tick action and take a quick, small profit, reducing reward as well as risk. It is important to have explicit profit targets. These may be pivot points, support/resistance levels, etc. Moreover, these targets should enable you to enjoy as much reward from trades as risk. Some of my own targets are indicator based: if I'm short, for example, I will cover at least some of my position if we get very negative TICK readings on enhanced volume, regardless where that price level may be. Once you establish your targets, practice in simulation mode letting trades run until they either hit the target or are stopped out. While the trade is running, you practice keeping yourself chilled with those relaxation exercises. You can't develop confidence in a trade if you never let the trade run. Simulation is a safe way to build experience and confidence.

I am often asked why I don't accept advertising on my blog, and why I don't participate any more in the popular trading conference events. One important reason is that I want the freedom to speak my mind, with as much honesty and integrity as I can muster. Our reader's email is not unusual in my experience. Writers blithely quote statistics that 80% or more of traders lose money, but rarely do we stop to consider that trading is creating pain for 80% or more of its participants.

Trading can be an incredibly destructive activity. You can pour money and dreams into trading without a demonstrable edge, go against professionals who have the best in research and execution, and you can lose everything.

Lose a house? Lose all your money? Lose your marriage? I've seen it all with traders. For every fortune made, I've seen many, many dreams dashed.

No one in the trading magazines, books, or seminars talks about that. One time I did mention it in a seminar and was told by the conference organizer to not talk on that topic further. I have not appeared at that conference since, by their wishes as well as mine.

The trading industry exists to get people to trade. Brokerages offer products that will get people to trade more. Software firms build in features that make it easier to place orders. Coaches and vendors offer promises of trading for a living and winning in markets.

But no one talks of the pain. No one wants to read the dozens and dozens of emails I receive every week from traders who are hurting.

So I choose to speak my mind without fear of commercial repercussions: If you're going to trade, do it the right way. Don't traumatize yourself. Observe and research before you trade; practice trading small and in simulation mode before you put your capital at risk. Don't abandon your day job until you have a track record of consistent profits across various market conditions. Trade less, not more: emphasize the high probability trades and keep your capital safe in the interim. Forget about riches and don't put yourself in a position where you need to trade large and often to make a living; work on covering costs consistently and managing risk. If you don't see objective evidence of an improving learning curve after a year or two of consistent effort, consider the possibility that your talents lie elsewhere.

Trading may or may not produce gain, but it should not be a continual source of pain. No one has ever traumatized themselves to success.


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