Monday, October 29, 2007

Views From the Trading Penalty Box

At 10:50 AM CT, I placed myself in the penalty box. What that means is that I'm done trading for the day.

Actually the day started out just fine. I hit a new equity curve high last week and felt I was seeing the market well. My first trade Monday morning was a classic false-breakout, fade-the-strength trade and resulted in a several pt winner in ER2. My second trade pressed the downside in NQ and escaped with a half-point winner as the downside follow through never materialized.

That last trade should have told me that the downside was limited and warned me about continuing to sell the market. Moreover, what the hell was I doing fading NQ when the semiconductors were catching a bid and the Russells were still leading the downside? Worst of all, I didn't ask those questions before launching into my third trade: selling ES a little after 10 AM CT.

The market moved smartly against me, but I was seeing volume slow down and no outstanding sector strength, so I hung in there. One point against me. Two points. Then three. To say I was disgusted with myself would be an understatement. Not only had I failed to ask the right questions before entering my trade; I also left my stop fuzzy--not something that got me making the money in the first place.

I had a strong sense that, if I covered, I'd be buying the highs, so I established a firm catastrophic stop and waited the market out. Fortunately I got a retracement and managed to get out with a one-point loss about 50 minutes later. Much longer than I should have held a trade like that.

All the while, as the market moved back my way, I told myself that my trading day was done. It was in the penalty box for me. That was just an ugly trade.

I bring up this episode because it illustrates several lessons:

1) You never stop working on your discipline - I don't care how many letters you have after your name or how much you're up on the year. You stop executing the fundamentals and doing what got you where you are and you'll pay a price.

2) Overconfidence kills - It's when things are going well and I'm feeling good about trading that I tend to be sloppiest. The key, for me, is to always trade as if I'm down money. That keeps me sizing positions reasonably, waiting for good entries, defining my stops clearly, and being selective in my trades. Fear and greed may get top billing, but overconfidence is one of the greatest trading challenges.

3) The penalty box works - There was a time when I only entered the penalty box when I went through decent-sized drawdowns. Now just one bad trade can take me out of the trading day. That may seem harsh, but I can't tell you how much money and anguish it has saved me. I spend the rest of the day identifying what I did wrong and making sure it doesn't carry over to tomorrow. In August, I entered the penalty box after a couple of good trades that lost me money. The market wasn't doing its usual thing; my ideas weren't working well. By shutting down my trading for a little while, I came back when I had a feel for the market and was able to add to a profitable year.

I've been trading since 1978. I have a doctoral degree in psychology and work with traders professionally. I average well over 100 trades a year and have read most the major trading and trading psychology books.

Still I make the mistakes. Still I learn from experience. Still I visit the penalty box.

Sometimes it seems as though the only progress I've made in decades of trading is that I enter the penalty box a helluva lot quicker than I used to.

But that has made all the difference.


Understanding Overconfidence and Underconfidence in Trading

The Most Common Trading Problem