In years of working with
hundreds of traders, from beginner to advanced, we have observed
several common misconceptions and limiting beliefs traders share when
they are starting out. They will frequently make the same mistakes and
deal with obstacles placed in their way in a similar manner.
Their ability to overcome
these will determine to a large extent the level of success they
subsequently achieve in trading. While a number of these are common
knowledge and are dealt with extensively in existing trading
literature others have received less attention. We would like to share
some of our observations with the reader in the following article.
Under-Capitalization and Unrealistic
Expectations
Some of the most damaging
misconceptions and limiting beliefs are planted in would-be-traders
heads to entice them to enter the industry, before they ever execute
their first trade. The biggest one, by far, is that trading is easy
and that people can make obscene amounts of money within days of
starting out on the tiniest amount of trading capital.
While it is certainly true
that the markets offer unlimited potential and everyone has heard
stories of traders borrowing a couple of grand on a credit card to get
started who subsequently went on to parlay that into a small fortune,
the reality is that trading requires time, preparation and sufficient
start-up capital. Starting out with too little capital and unrealistic
expectations sets would-be-traders up for failure and is damaging in a
number of ways, for example:
a) People who
start on a shoestring are forced to take on too much risk, and have
a significantly greater risk of ruin than better capitalized
traders. Someone starting out with $3,000 in the E-mini S&P's will
have to risk $150 to $600 pr. trade, or 5-20% of their equity on
each individual trade. As a result they will be 'wiped out' if they
have a handful of losing trades in a row.
Contrast this with
someone trading the same approach on a $10,000 account. Each loss
will represent a significantly smaller percentage of equity and they
will be able to weather the inevitable drawdowns that occur from
time to time. Regardless of the approach employed, one should have
sufficient capital to be able to withstand at least 10 losing trades
in a row and still continue trading. The smaller the percentage of
equity risked pr. trade the smaller the risk of ruin will be.
Research has shown that ideally one should not risk more than 1%-4%
of equity pr. trade.
b) Unrealistic
expectations cause traders to discount the progress they are making
and lead them to 'force' things to bring about the desired result.
As an example: If you believe you "should" be making $1,000 pr. day
pr. contract in the S&P's when daytrading and find that you are
'only' up $300-$500 by Wednesday after trading for 3 days you will
be unhappy with your results.
Instead of continuing to
do what got you to that point in the first place and winding up with
perhaps $800-$1,000 for the week you will start pressing, pushing
for trades, trying to make things happen, taking questionable trades
giving back in the process what you'd made to that point and wind up
maybe -$1,000 or more in the hole for the week!
In trading, as in any
profession, it takes time to gain sufficient proficiency and one must
learn to crawl before they can walk. By being adequately capitalized
and budgeting several months to a year at a minimum to learn the
basics of this profession beginning traders give themselves the best
chance of succeeding.
Confusing Margin Requirements with
Capital Requirements
One frequently hears
starting traders talk about the minimum margin requirements set by the
futures exchanges as sufficient capital needed to trade a particular
contract. Beginning traders will also look to the margin requirements
as a way to determine which market to trade, saying things such as "my
account is so small I can only 'afford' to trade Soybeans and Wheat,
because they are the only contracts with a small enough margin
requirement".
The fact is you can't
'afford' to trade any market unless you have a winning approach! If
you don't you might as well hand over your money to the nearest
charity and save yourself the aggravation, because you will lose it
anyway!
Margin requirements are set
to protect the integrity of the marketplace, they are intended to make
sure that traders have sufficient capital on hand to meet their
obligations should the market move against their position. They are
calculated based on a specific formula that takes into account the
volatility of the market in question.
Generally speaking, as a
rule of thumb, they are approximately equivalent to the 3-day true
range of that market. Margin requirements should never be used to
determine the market, or number of contracts, to trade. Doing so leads
one to risk too great a percentage of equity on any given position.
Belief in Mechanical Systems
(i.e. the best system, the best
hardware, the best software, the best data etc.)
It never ceases to amaze us
how people believe the process of trading can be automated and all
they have to do is find a system that works and then they can kick
back on the beach with a pina colada in hand, call their trades in on
the cellphone and sit back to collect the checks. To these individuals
life becomes a never-ending search for the "holy grail" of trading.
They burn the midnight oil
looking for the ultimate oscillator that will make them rich, sweating
over the cleanest source of data, which type of data is better,
continuous or back-adjusted, looking for the best trading execution
platform, the best charting software etc. In our observation these
people are so wrapped up in the mechanics and intellectual exercise of
trading that they never learn how markets actually work, i.e. that
markets are driven by fear and greed and emotional crowd behavior and
that price behavior cannot be reduced to a mathematical algorithm.
These individuals might
have been around the markets for a long time and claim several years
experience, but in fact they've only got 1 year of experience several
times over.
Psychologically Untradeable Mechanical
Systems
While there are a handful
of commercially available mechanical systems that have decent track
records and show profitability over time, the reality is that those
systems are what we call 'psychologically untradeable'.
What we mean by that is
that they frequently have large drawdowns and those drawdowns may last
for months. Most people are not prepared to stick with such a system
through the drawdown and will usually abandon them near the bottom of
the equity curve before the systems 'get back in sync' with the market
and move to new equity highs.
The thing most people miss
when evaluating these systems is that they underestimate how hard it
is to stick with a system through a drawdown period. It is easy when
looking at a track record, one will 'experience' the drawdown in a
matter of minutes, intellectually acknowledging that there is a
significant drawdown, but then the system invariably pulls out of it
and winds up being profitable for the year.
There is a world of
difference between accepting a drawdown on an intellectual level and
then experiencing that drawdown over a period of several weeks or even
months on an emotional level, wondering whether the system has finally
had it and is never going to pull out of the 'nosedive'.
Belief that Losses can be Avoided
Refusal to accept the fact
that losses are an integral part of the game and a belief that they
can be avoided leads to strange behaviors. This belief leads to
'paralysis by analysis' and problems pulling the trigger. Trading is a
game of probabilities.
At any point in time there
is an X % chance that a move will take place as anticipated, this
means that conversely there is a (100%-X%) probability that it won't!
When implementing a trading strategy one should be cognizant of this
fact and plan accordingly, i.e. not risk more than Y% of capital on
any trading idea/opportunity, as there is always a certain probability
that one is wrong.
Regardless of how good your
method is, even if it can be demonstrated to have 99% winners, you
will still lose all your capital if you risk it all on every single
trade. Another fact to keep in mind is that wins and losses are not
evenly distributed and nicely packaged in a tidy series (for the
previously mentioned 99% winning system that would mean a series of 99
wins, 1 loss, 99 wins, 1 loss). Even a 99% winning system will
occasionally have several losses in a row. This brings us back to the
differences between accepting/understanding things on an intellectual
level vs. an emotional level.
While traders may
understand intellectually that losses are a part of the game, they
still want the particular trade they are in at any given point in time
to be a winner and are prepared to add to their position, move their
stop as the market moves against them, or cancel it altogether to help
secure a positive outcome. This behavior and belief leads to traders
being forced to eventually take losses that are significantly bigger
than allowed for in their trading plan.
Belief that Every Move can be Predicted
/ Belief in Missed Opportunities
Starting traders (and a
number of experience ones :-) spend a lot of time fretting over missed
opportunities. They play the "would'a, could'a, should'a, wish I had'a"
game, kicking themselves over missing opportunities they believe they
could have taken advantage of. Aside from being demoralizing and
damaging to the psyche this practice is an unproductive waste of time.
Frequently traders will also introduce as a reason for taking a trade,
information that wasn't known at the time the move took place.
The fact of the matter is
that trading is a game of probabilities and at any given point in time
a move may happen out of nowhere that was totally unforeseeable. Some
people have estimated that there are 12-20 decent swings in the S&P's
in a week and that you are trading like a pro if you catch 3-4 of
them. In that respect trading is similar to baseball, the guy batting
.300 is doing one heck of a job and gets rewarded accordingly!
Price information from Electronic
markets vs. Open outcry markets
Each month we hear from a
trader or two who have discovered how to make money arbitraging
between the E-mini S&P and the 'big' S&P contract. They've observed
that the E-mini always moves ahead of the 'big' contract and developed
a strategy for taking advantage of this. What they fail to realize is
the difference between the 2 markets. The E-mini S&P trades
electronically on GLOBEX, as a result all transactions are reported
immediately when orders are matched, whereas the 'big' contract trades
in open outcry on the CME trading floor.
Since it is an open outcry
market pit reporters must record the prices and report them to the
exchange which in turn distributes them through the price quotation
systems. This human element introduces a lag of anywhere from a 5-25
seconds or so. As a result the E-mini may appear to lead the 'big'
contract, when in fact they move virtually identically.
Another misconception we
frequently encounter with off-the-floor traders is that they believe
the trades they see on open outcry markets such as the 'big' S&P took
place in the order they are reported on the datafeed. For the most
part that may be true, except when 'fast market' conditions are
declared in the pit.
In those instances pit
reporters will try to make sense of the pandemonium in the pit and
enter the prices in an orderly fashion, i.e. 800, 801.50, 802, 803,
802.50, when in fact prices might have been at 3-4 different levels at
the same time in different sections of the pit. In this way datafeeds
inspire a false sense of security in fast market conditions and may
cause off-the-floor traders to enter trades at times they would be
better off standing aside.
These are but some of the
concerns we address with students at our workshops. Trading is not
just about picking good entries or 'timing the market'. You have to
have a structure and framework to read/analyze the price action and
combine that with a coherent comprehensive trading strategy that
allows for the element of chance.
Ron Schoemmell and
Valdi Thorkelsson
R.S. of Houston Workshop
www.rsofhouston.com
About the authors: The
authors have accumulated 25+ years combined experience in trading and
have been running the R.S. of Houston Workshop since 1996. Info about
their workshops can be found at www.rsofhouston.com
P.O.Box 890648 Houston, TX 77289-0648