The typical evolution of a trader goes something like this. You have read a few magazines perhaps bought a few shares you may even have seen Wall Street on video. You go to bed Sunday night, wake up Monday morning and decide that you are a stock market trader.
Not too implausible you think, after all you have probably been able to master a few skills in your life, why not trading. Well consider a variation on a theme, imagine that you have seen a few episodes of ER perhaps you have even been to the doctor once or twice. On the basis of this background you decide that you are more than adequately qualified to be a trauma surgeon. Sound silly, it is no sillier than deciding to trade the stock market without actually having any background as a trader.
You may consider yourself a trader on the basis that you have made a little bit of money in the current market. But consider carefully the following questions, which are arranged in order of importance and see if you can answer them.
- What is your position-sizing algorithm, is it loss based or volatility based.
- What is your exit trigger, more commonly known as stop losses.
- What is your entry system.
New traders face a variety of hurdles as they embark upon their trading career, what I will do in this article is touch upon a few of these problems and hopefully offer a few pointers that will assist traders.
A lack of skill.
One of the key problems that new traders face is that they confuse their skill with the luck of having entered the market during an extraordinarily powerful bull market. Most new traders are incapable of acknowledging that they know very little about the markets. Reconsider the first few questions I posed, these are some of the most basic of questions that all professional traders simply take for granted. If you cannot answer these questions then you should acknowledge that you do not know anything about the basics of trading.
However, do not be too harsh on your self, most professional market advisors cannot answer these questions either. If there are any true secrets of trading they are to be found in these three questions. If you are to succeed as a trader it is essential that you be able to answer these questions and to understand their role in your trading system.
A lack of a trading system.
My own anecdotal observations would suggest that the vast majority of traders simply have no concept of what a trading system is. Your trading system encapsulates your approach to the market, it defines everything from your objectives as a trader to which markets and which time frames you will trade. Your trading system is in essence your business plan.
It is imperative that as a trader you have a rules based approach to the market. It is important to have rules to guide you as you trade for two reasons. Firstly there are no rules for trading imposed upon you the market has no rules for how you should trade. Any rules you generate are your own as such they have to suit your objectives as a trader and you personal approach to the market.
Secondly having rules removes the emotion from trading. Many traders have the wrong idea about trading, they assume that it is some testosterone driven environment where there is a lot of yelling and screaming each day is a confrontation that needs to be won. Nothing could be further from the truth. Trading is a calm, disciplined profession, the moment your emotions creep into trading you are lost. Certainly the popular image of trading is one of a very boisterous environment, generally dominated by males. This image is a false one but unfortunately it infects the psyche of a trader and leads them towards failure. It also acts a barrier to women who want to enter trading as a career. Such a development is unfortunate because the available evidence suggests that women are better traders than men.
Traders must have a trading system, if you have no system you will fail.
Much of a trader’s day is spent managing information. In trading there is no shortage of information. It is possible to track the opening and closing of all major world markets courtesy of cable television. The internet has brought the dealing desk into the home with vast information resources available via the pc. It is possible to subscribe to magazines from all around the world, you can even get the Wall Street Journal on line as it is delivered to homes in New York. You can even get research from broking houses although the available evidence suggests that you would be more profitable doing the opposite to what your broker recommends.
There is a problem with all this information. It is largely irrelevant to the professional trader. None of it is provided by people who actually trade for a living (this includes stockbrokers who are commission sales people). New traders are unfortunately prone to trying to find as many sources of information as possible. As a consequence of this they suffer from two conditions the first goes under the traders euphemism of the paralysis of analysis. Too much information causes the trader to literally seize up and be paralysed into inactivity.
The second problem with information overload is more insidious and probably more important. Humans have some unique idiosyncrasies when it comes to processing information. The first is related to our confidence in our decision- making ability. Let’s assume that we are trading NCP and we receive a single piece of information and we are asked to rate how confident we feel about any outcome based upon the limited information we have received. We can for the purpose of the exercise assign an arbitrary weighting to our confidence. Lets say that with one piece of information we are 10% confident. If we get another piece of information our confidence ma go to 20%. This is reasonable we have doubled the information we have received so our confidence level doubles. However, if we get three sources of information our confidence level instead of going to 30% will suddenly rocket to 90%. Traders become disproportionately more confident with a slight increase in information.
An additional traders quirk applies to how we process more and more information. The more information we get the more we focus on the superfluous and the irrelevant. What has been found is that traders become less accurate the more information they receive.
Whilst it is psychologically comforting to feel that your opinions are validated by the opinions of others there is overwhelming evidence that you will not get rich listening to the advice of others.
The new trader needs to manage the information they are receiving to ensure that they are receiving information that is only pertinent to them and is not tainted by the opinions of others. Traders need raw information not recommendations.
Within this management of information the technical trader needs to be addressed. Technical analysts may initially assume that because they use purely price to dictate their actions then they would be immune from the problems of information management faced by other traders.
Unfortunately for the technician this is not true. You will remember that the least important question that I posed in my introduction was what is your entry trigger. Entry triggers comprise probably about 10% of trading. Most technicians ignore this and scour the globe looking for the one perfect indicator, many buy software packages containing what is called the ultimate indicator. The most popular question I am asked at seminars is what is the magic number for my moving average. Yet when subjected to rigorous testing technical indicators are shown to under perform random probability in the validity of the trading signals they provide. There simply is no perfect set of indicators, your indicators should simply act to get you into the position and that is all, and that is the least important part of trading.
I have saved the most important till last. Typically when a trader enters the market for the first time they start thinking about how much money they will make. The reality is that a new trader may never make any money because reward is a phantom that may never exist. The only constant in markets is risk. Despite the current vogue in stock market advertising there is no such thing as a risk less trade. Markets only operate because of the risk reward equation. No risk no reward.
Risk can never be eliminated only managed. Professionals have always known this and it is reflected in the approach they take which is not to make money but to minimize the amount they can possibly lose. This is why the first two questions I posed relate to position sizing and exit triggers. These two techniques ensure a trader’s survival when a trade goes wrong. As such they are the most important questions in trading.