Saturday, February 21, 2009

Profiting From Our Trading Mistakes

A frustrated reader asks:

How do you handle getting scared out of a position only to be wrong and as the days and weeks go on you keep counting how much money you could have made had you not panicked? I guess the question is how do you let go of a mistake? I had a bearish put spread on the DIA and I let the 1/28 rally spook me into thinking we were about to get a hard and fast counter trend rally. I dumped my position at 3:45 pm EST and here we are 10 points later and lower.

The novelist philosopher Ayn Rand used to advise readers to "check their premises." A premise embedded in the trader's question above is that getting stopped out of a trade that eventually proves profitable is, indeed, a mistake.

If markets expand their volatility, it's not difficult to be stopped out of a position due to mere market noise. You may set your stop just above a trading range, and the market will move well above that point before reversing and trapping the longs.

In such an event, is it getting stopped out that is the mistake, or is the mistake not re-entering the position once it is clear that we can't sustain prices at new levels of value?

The reader is right to point out that not letting go of the feeling of having made a mistake is costly for traders. Consider the recent post on learning from losing trades. If a trader can't let go of the loss, it's difficult to stay market focused and re-enter the trade. In fact, I generally find that such trades are better risk/reward propositions on re-entry, because they have given you validation that they cannot sustain a move against you. It's difficult to see that, however, if you become self-focused at the very time you need to be market focused.

An excellent addition to any trading plan would be a "what if" scenario that spells out what would have to happen to put you back into the same trade. As any soldier knows, it is much easier to take the right actions in the heat of battle if they have been planned and rehearsed.

On the psychological side, not letting go of mistakes is an example of internal dialogues going wrong. Those who have read the Psychology of Trading book will recognize the issue from Chapter Thirteen; in addition to the techniques outlined there, the cognitive restructuring methods laid out in Chapter Eight of the Enhancing Trader Performance book can be quite helpful.

The gist of these efforts is to recognize your thought process as a conversation that you are having with yourself. Once you become aware that many of your internal conversations are actually ways of venting frustration and anger, you can consciously adopt a different tone of conversation in your self-talk. Changing your self talk is like changing any habit pattern; it requires initial effort and repetition; the payoff is that you are then freed to stay market focused at times when other traders are focused solely on themselves and their P/L.

Ultimately, the only way to let go of losing trades is to learn from them. Maybe the trade teaches you something about how the market is trading: information that can help you frame the next trade. Maybe the trade teaches you something about where you place stops and how you manage risk: that will help you avoid future losses. And maybe the trade will teach you to work on yourself and the relationship you have with you when the chips are down.

Losing trades can be the best learning experiences, but only if we're not mechanically repeating our losing psychological patterns.