Saturday, March 21, 2009

Learning When to Not Trade

The previous post emphasized managing the psychological risks of trading as a key challenge for those learning to trade. An astute reader commented on the post, noting that limiting daily losses and taking time outs are important trading practices.

I could not agree more heartily. Many times traders press too hard to make money, leading to overtrading. Instead of trading for logical reasons (their edge), they trade for psychological reasons. That trader with the 55% win rate suddenly becomes a trader with a 45% win rate when overtrading. Without limits on daily losses and a process for taking a time out, that trader can blow up in a short amount of time.

The other reason it's important to limit daily losses and take those times away from trading is that markets themselves go through shifts. Adapting to changing market conditions is a challenge even for the most experienced and successful traders. When hedge funds and CTAs experienced redemptions from investors, their trading patterns changed; that has made 2009 a very different environment from 2008 across a range of markets. Similarly, when computerized trading began to dominate market making, many of the profitable ways of scalping markets dried up.

Because market conditions change periodically, one's edge in trading is never fixed. We go through periods of greater or lesser edge. For that reason, a central skill to long-term success is recognizing when your edge is eroding and pulling back from risk taking.

I saw this first hand at proprietary trading firms during the low volatility markets of 2005 and 2006. Traders who did not adapt to those conditions and reduce their profit expectations (per trade, as well as per week and per year) fought the slow, choppy markets and did not last to see far better conditions in late 2007 and 2008. Similarly, many daytraders who raked in money during the tech boom of the late 1990s did not pull in their horns after early 2000 and lost their money and their trading careers.

The takeaway message is that successful traders are always students of markets, always learning, and always adapting. They have periods of feast and famine, and they learn to keep themselves afloat during the lean times so that they can participate when things get better. In that context, learning when to not trade is a crucial component of trading success.