Thursday, August 15, 2019

Common Mistakes I See Traders Making

It's interesting to see:  for quite a while, traders lamented the lack of volatility in the stock market.  Now that we're seeing an elevated VIX and larger daily price ranges in the index products, a new set of woes has come to the fore.  Many traders are perceiving an enhanced opportunity set, but are having problems capitalizing on it.  Here are a few mistakes I see traders making recently:

1)  Assuming that patterns that worked when VIX < 12 will work similarly in the higher volatility environment.  When we have elevated volatility, the greater movement is present across time frames.  What was a good, tight level for a stop loss point will be blown through in the higher volatility environment.  Simply adjusting stops linearly with volatility also doesn't work, as each unit of trading volume produces more movement, precisely when volume is expanding.  It is not a linear function.  Another example is that traders assume that oversold points, for example, will lead to bounces.  In the low VIX environment, which is often one of rising prices, that pattern may work.  When we get significant downside, short-term oversold can easily lead to further oversold.

2)  Overexcitement.  Traders equate movement with opportunity.  That's not necessarily the case.  Movement is only opportunity if we have studied/backtested it and made sense of it.  In the heat of overexcitement, traders will size up positions right at a time when their stocks or indexes are already providing more movement.  The combination of larger size and higher volatility leads to much larger P/L swings, which can lead to debilitating losses and a much worse mindset going forward.

3)  Poor review processes.  In the busier market environment, traders do more trading and leave less time for reviewing and studying their trades.  At SMB, traders work with the "playbook" concept introduced by Mike Bellafiore.  Just as a quarterback and football team works with a playbook to prepare for games, traders have playbooks of the trading patterns that they have tested and successfully employed.  Per the first point above, traders forget to update their playbooks when market conditions change, just as football teams change their playbooks to exploit specific opponents.  But a changing market environment should call for a doubling down of review, to clearly identify what is working in the new regime.  If traders become so busy trading that they spend less time grading their performances, setting goals, and making adjustments, they will underperform the perceived opportunity set.

The key takeaway is that we always play in unique environments.  For the professional bowler or golfer, one tournament site is not like another.  For the football or soccer player, field conditions can change.  Many of the mistakes we make as traders involves failing to make the right adaptation to the environments we find ourselves in.  All the self-help mantras and techniques will not help if we fail to identify and make the right adjustments to today's conditions.

Further Reading: