Thursday, August 14, 2008

More Thoughts on Mindful and Mindless Trading

I was pleased to see that my recent post offering thoughts on trading stress and emotions generated a bit of controversy. I appreciate comments to the posts, including those that push back and stimulate a little more consideration of the issues involved.

The point that generated some discussion was my example of the currency trader who blindly entered a position in euro/U.S. dollar without any awareness that a key piece of economic data was coming out in Europe. It was a known market mover, and the trader was blown out of his position with a significant loss. My comment was that "this represents trading at its worst."

Here's why:

It's a question of awareness. Had the trader *known* about the report, known the expected volatility around the news, and placed his trade accordingly--sizing it to reflect the increased volatility and placing stops around the expected noise around the news--this could have been a fine trade. If you think, for instance, that the fundmentals support a weaker euro relative to the dollar because of bearish economic fundamentals in Europe and if you see technical reasons to be long U.S. dollar, then placing a core trade ahead of the news in anticipation that the news may be a catalyst for your trade could be *excellent* trading.

The key is that the trade is planned, with full awareness of what's happening in Europe and the U.S. and with conscious reasons for being in the market. The stop-loss point would reflect that point at which you decide that: a) the news is not a catalyst; b) the news is so dollar-bearish that the fundamentals have changed; or c) the move is sufficiently adverse that the technical picture has changed.

But, no, that's not what the trader in my example did.

He had no more reason for being in the trade in the first place than a simple, superficial chart pattern. The pattern involved short-term market strength, but was neither confirmed by any longer-term, contextual technical analysis or by any fundamental view. Was there overall bullish demand for the dollar or overall bearish supply overhanging the euro? The trader had no clue, never looked at other currency crosses. It was simply a shape on a chart, and it was never tested for any kind of edge. That was the first shortcoming.

The second shortcoming of the trade was that the stop was placed in ignorance of the news report and the increased volume/volatility of that market around the news. The same was true of position-sizing: the trader had large size on the position, in ignorance of the report. This greatly increased the odds that: a) the trade would get stopped out on normal, expectable noise around the trade; and b) the trader would lose a meaningful sum because of the trade sizing.

In short, it wasn't the fact that the trader was in the market before a news event that constituted bad trading. It was the fact that the trade was placed mindlessly, without thought and awareness, without any demonstrable edge, and without any realistic planning. "Here's a good shape on the chart, let's go for it," was the sum and substance of the trade idea. That's why it was "trading at its worst."

Too often, such mindless trading is justified by having a "feel" for the markets. Intuition is important in trading and can reflect a sophisticated pattern recognition that comes from years of experience. But even an intuitive currency trader (and I know several good ones) understands his/her markets and doesn't place large-size trades with relatively close stops ahead of market-moving news. Very often, intuition will prompt an idea; analysis will confirm it; and planning will guide the execution. There's no conflict between being discretionary/intuitive and being planned/thoughtful once you distinguish the genesis of an idea from its validation and execution.

Thanks for the opportunity to clarify an important issue. For another interesting debate on an important topic, check out the Daily Speculations site's recent back-and-forth about stop-losses and whether or not they add value. My short take on the question: they do add value, especially when they are conceptually based (i.e., based on considerations that the reasons underlying the trade have changed, not just based on a particular price/loss getting triggered) and when they are placed in the context of expected market volatility and proper position sizing.