Common Mistakes Traders Make - 3: Reacting Rather Than Acting

 

It's a common misconception that acting rationally means eradicating emotion from our thought processes.  Indeed, the opposite is the case, as psychologist Nathaniel Branden observes.  Our greatest ideas are ones that we feel deeply, that resonate with us.  That is what traders mean when they refer to having "conviction" in a trade.  Our worst trading occurs when we feel things and react to those impulsively.  In those cases, our reacting prevents us from reflecting and thinking clearly.  Everyone feels uncomfortable when markets move against us.  The question is whether you use those emotions as information or allow them to control your next actions.

Most traders have had the experience of looking at market information, discussing ideas with others, and scouring research and suddenly see where things are lining up and making sense.  That aha! moment is a great example of feeling deeply.  Our greatest ideas are ones that come to us with that deep sense of recognition.  Those are the ideas we're meant to act upon.  Acting means directing ourselves toward a chosen end based on all the information available to us:  factual information and also information from our deepest feelings.

When we react, we are not directing ourselves toward a chosen end.  Rather, we are allowing events to control us and dictate our actions without planning and without conviction.  Little wonder that some of our worst trades come from decisions made out of fear, greed, FOMO, etc.

We think most deeply when we quiet our minds and shut off our internal chatter.  It's when our minds are still that patterns in the world can come to us and give us that sense of aha!  A quiet mind is an open mind and an open mind is ready to feel deeply.  One of the greatest edges in trading is the ability to approach markets with a still, quiet mind.

Further Reading:

Why Trading Psychology Matters

Blueprint for an Uncompromised Life

Radical Renewal

.

Common Mistakes Traders Make - 2: Acting Before Understanding

 

In the first post in this series, we took a look at how traders often lose their ideas when their stop levels are hit.  In this post, we'll examine a different, but related, cognitive mistake.  Many traders will place trades based upon price patterns and "setups" without truly understanding how their market is behaving.  This is a particular problem when market regimes change and markets change their behavior.  Knowledge is necessary, but not sufficient, in trading success.  We also need to understand what is happening in our markets so that we can profit from the behavior of other market participants.

One variable important for understanding is volume and especially changes in trading volume.  If volume is increasing in a stock, index, or other instrument, it means that new participants have entered the market.  We want to examine how our market responds to this expansion of participation, because that will provide us with important clues as to who is in the market and how they are leaning.  For instance, if we're trading a small cap stock with a relatively small float, a meaningful expansion of volume almost certainly indicates speculative interest among small traders.  These traders are active as daytraders and often pile into momentum when a stock moves.  Knowing this, we can get ahead of their activity.  A large cap stock, on the other hand, is dominated by institutional traders who will wait for good prices and execute their orders over a period of time.  If we can study the stock and see how it has moved on high volume in the past, we can reverse-engineer the execution algorithms used by the large traders and front-run their accumulation of shares.  Stocks index volume is often significant as a function of time of day, as different participants are active at different time zones and times within each zone.  When we see volume expanding and a breakout early in the U.S. session, this often has implications for trending through the day.

Another variable important for understanding is the correlation among related market instruments.  If an auto stock is making a move, it pays to check out other auto stocks and the broader list of industrial shares.  We want to determine if this is an idiosyncratic move, specific to the company, or whether institutions are accumulating shares in particular industries and sectors.  Seeing how sectors behave before we trade can help us distinguish between rotational environments, which are often rangebound, and trending environments.

A football team would never call a play without checking out the defense of the opponent.  Similarly, we want to understand the market environment before we call a play with our capital.  When we act before we understand, we implicitly assume that all price patterns are equal in their meaning and significance.  If that were true, wouldn't sophisticated algorithmic participants already have mined such simple "setups"?  It is precisely the complexity of movement at different levels of participation, different times of day, and different co-movements of instruments that makes trading challenging, even for the algos.  Great traders don't have a passion for trading; they have a passion for understanding markets.  That's what makes professional trading different from gambling.

Further Reading:

Learning to Trade:  Market Cycles

Learning to Trade:  Building Our Understanding

.

Common Mistakes Traders Make - 1: Losing Ideas When We Stop Out Of Trades

 

Yes, it's true that problems with our mindset can interfere with good trading.  It's equally true that bad trading can interfere with our mindset.  In coming posts, I will highlight mistakes I see traders make and what we can do about them:

The first mistake I see traders make is confusing the idea being traded with the actual trade that is placed - Traders develop ideas about the markets or stocks they're trading.  Those ideas often reflect what is happening over time with growth and other fundamentals, price action and trends or breakouts, etc.  For example, I might develop the idea that a data release is a game changer for the stock market and should lead to new highs in SPX.  Once we develop an idea, we have to translate that idea into a specific trade.  What will tell us that traders and investors are acting on this idea?  What will give us favorable reward-to-risk in putting on a position to profit from the idea?  Too often, traders will get stopped out of the trade and stop following the idea--only to see it play out subsequently.  The trade is not the idea.  A trade that doesn't work doesn't necessarily mean that the idea is invalid.  It simply means that market participants, right here and now, aren't acting on the idea.  When we stop out of a trade, we need to review:  Is my idea still valid?  

If my idea was that we're breaking out of a long-term range and should head meaningfully higher due to economic growth and positive earnings , but then a Federal Reserve action is announced that drives the market lower, it may well be the case that my idea is invalidated.  We're not breaking out of the range to the upside and an important catalyst is now threatening a downside break and perhaps economic weakness.  

Conversely, if my idea was that we're breaking out of a long-term range and should head meaningfully higher and I then buy the next move to the upper end of the range only to see the market move back into the range, my breakout trade is wrong and I may very well stop out, but nothing has invalidated my idea about growth and positive earnings.  In such a case, I may retain the idea even as I jettison the trade and will ask myself what I need to see to re-enter a position.  Perhaps next time, I'll wait for an actual breakout to occur on increased volume and then I'll join the price action for a momentum move higher.

The psychological mistake we can make when we stop out for a loss is that we can become frustrated and, out of that frustration, toss aside the idea we were considering as well as the trade.  The wise trader looks at a losing trade as information.  It might provide information about what we need to see to make the good idea a good trade; it might provide information that the idea isn't so good after all.

Bad trading is sticking with ideas out of stubborness.  Good trading is sticking with ideas when they have not been invalidated.  This is why risk management is important.  If we control our bet size, we give ourselves plenty of room to go back and express ideas in new ways after initial trades don't work.  Conversely, some ideas end up being incorrect.  Knowing what will disconfirm your idea is just as important as knowing what will disconfirm your trade.

Further Reading:

Radical Renewal - A Blog Book on the Spirituality of Trading

Two Mistakes I See Traders Making

Three Common Mistakes Traders Make in Their Trading Reviews

.