“Markets don’t beat traders, traders beat themselves.”
– Jesse Livermore
“The trader is often the weakest link in any trading system”.
– Dr. Alexander Elder
“Markets are never wrong, but opinions often are”.
– Paul Tudor Jones
March 21, 2018
These well known quotes from respected traders address the single most important element of trading and investing. Emotional involvement. It has been reported for decades that most mutual fund managers underperform the index, that most mutual fund investors under perform the fund itself and that most, not all, but most, retail traders lose money over time. The performance issues usually are a result of the traders actions. For the most part, we all have access to the same charts and data. My belief is that people can not completely eliminate emotions from the trading/investing process, but it is very possible to reduce the emotional involvement with careful planning and concerted effort.
Recently, I have heard from many fellow traders who have become concerned with the recent market volatility, but also emotionally drained from the wider swings. 2017 was a period of record low volatility, and markets may be reverting to a period of more normalized daily swings or higher. For many, it takes some adjustment time after the long, steady low volatility uptrend of 2017. Here are 6 ideas below that may help you reduce emotional involvement and deal with this new level of volatility, which may be with us for awhile.
1. Settle In On Your Objectives
One of the biggest mistakes that traders/investors make is to try to do too much in markets. Individuals should identify what type of an trader they want to be. Longer term or shorter term, fundamental or technical, trading with the trend or counter trend.
While some are able to integrate different styles, for most it makes much more sense to focus on one style that best suits their personality. Some people are wired for a shorter term, day/swing trading style which allows them to try to book some profits on a daily basis.
Others, like myself are better suited for a longer term position trading approach, where winning positions can be held for a year or longer, while losing positions can be cut in s few days if stop losses are hit.
The shorter term approach can be mentally taxing, staring at a screen all day long, and many have expressed that it is not best suited for them, for some, however, it is. Each individual should spend some planning time an determine what time frame they want to follow and what trading objectives they have. Once you identify a style and time frame that works for you, it pays to build a trading plan around that. If you decide to be a longer term position trader, then the daily swings up and down that don’t affect your stops should not affect you as much, and what shorter term traders are doing online should not as well.
2. Structure Your Accounts Properly, including Cash Allocations
Structing the trading account properly is as important as the blueprints for a house. A trader should pre- determine as many aspects of the trading process as possible. The benefit to quantifying the mathematical aspects of risk management and money management is that it let’s the trader do their planning outside of market hours so decisions do not have to be made in the heat of the moment. Emotions and money are a bad mix.
How will position sizing be determined? A fixed percentage of assets, or based on the stop loss. How will stop losses be determined? By a fixed percentage or by using some technical measure, such as ATR. How much risk per position is acceptable? How many total positions in the account? What is the target cash allocation? How many positions in the same industry? Structuring the accounts properly will help reduce emotional involvement.
3. Consider Multiple Time-Frames
This may sound contradictory to item one, but it actually helps tremendously. I first heard of the idea from Ed Seykota, a legendary systematic, trend following trader, who said that he keeps a side account for discretionary trades to keep himself “honest”.
I use this concept myself and it has helped my results and my mindset greatly. I do not take discretionary trades. I do however trade three different programs with different time frames. One is based around the 200 day moving average, one is based on new 52 week highs, and the third is based around a pullback into a rising moving average. The trade time frame for winners can be anywhere from three weeks to two years, based on the strategy and the position itself. This allows me to take incremental gains in the shorter term program, and keeps me actively involved, and also gives me the patience to sit in the longer term winners, which may not pay out for a year or more.
I will often take a shorter term (three weeks or so ) position in an ETF pullback and lock in gains after a few weeks or so, based on the trading program itself. I will also scale some winning positions based on pre-defined exits to lock in gains. Carefully planning and having multiple time frames serves a few benefits. It can help to add incremental gains along the way, as the shorter term winners do add up. It also allows the trader to feel they are as actively involved as they want to be, and allows them to stick with their longer term strategy even better. This approach has been compared to a “cheat meal” in dieting. When people follow a strict diet, it has been proven that having one meal a week, that is off the diet, maybe a pizza or some other favorite food, actually helps the metabolism and more importantly, gives the dieter that mental break to stay the course.
Trading is the same way. A solid long term position trading approach may not be very active on a daily basis, but as traders we all like to have some involvement or add a new position in what looks like a promising position. Pre-planning separate accounts and separate objectives allows the trader to accomplish this. It may make sense to start with only two approaches. One which is longer term and one which is shorter term. Keep the positions separate and the process separate. Also, in the shorter term account focusing on only one position, or two to start with will help keep stress levels lower.
4. Use Pre-Determined Entry & Exit Signals
The old saying is “stops in/emotions out”. Some like to debate the ability to reduce emotional involvement. It is not possible to eliminate it, we are human. It is possible to greatly reduce it. Think about this, if you buy XYZ stock and set a pre defined stop loss of 10%, and then commit to not exit the position early, not buy more on the way down and not move your stop lower, where is the emotional involvement on the stop? Buy XYZ at $50, set a hard stop loss at $45, (-10%), then leave it alone. This is the basis for rules based, systematic trading. It takes time and practice to do this, but this is one way to reduce emotions. If you limit your loss to the stop, why interfere with the trade?
If you set a pre defined entry signal to buy ABC stock when it makes a new 52 week high, or a new 50 day high, or when it closes over the 20 day moving average, where is the emotion here? The signal is black and white, if we allow it to be. This is another example of rules based, systematic trading. Once again, it takes practice and time. It also helps to develop some type of rules based system based on research and conviction that the signals based system can be profitable over time.
5. Tune Out Third Party Opinions
The Financial media’s job is to turn non stories into stories and to turn stories into epic dramas. Financial TV used to be a 5 minute segment on the evening news, now it is 24 hours. Their job is to keep viewers interested, and people love predictions and market calls. Entertainment however does not equal profits. During market hours, I have one of the financial channels on all day. I keep it on mute. I check from time to time the market averages, and see what story they are discussing, other than that, there is nothing that any analyst or pundit is going to say that is going to influence my trading process or the chart in front of me.
While Twitter and social media has many benefits as I have discussed in the 5 Ways to Use Social Media to Help You Become a Better Trader post, it also has many drawbacks. A lot of Twitter is very short term, very prediction and opinion oriented and often contradictory. Someone may be commenting on a shorter term position that they have, which has no bearing on your longer term strategy. Some seem to only post “winners”. This is not reality and not how the real world of trading works. In reality, you will have losing trades and losing positions, you will have a series of losing trades, as I discussed in 10 Things You Need Know About Risk, Risk Management, and Trading.
The fact is that every tick does not matter, and every new flash does not matter. Every one has to choose their own strategy. but making big money over time does not mean constantly doing something.
6. Do Less
I started trading in 1997. A that time I was convinced that the key was MORE. More of everything. More information, more charts, more screeners, (back then I used a newspaper), more symbols to look at, more indicators on my screen, more of everything. I literally read the Wall Street Journal, the Financial Times, IBD, Barron’s. company annual reports, listened to conference calls, and any other thing I could do to get an “edge”. After spending hours a day and weeks researching an idea, I would take my position and watch it unwind right away into a loser. Weeks of research down the drain. Or worse yet, do all of this, take my position, and then two hours later, read some new information, and get out of the position, only to watch it sky rocket without me.
Like many people, I thought that trading meant constantly doing something. making predictions or looking into the future. Buy in the morning, makes a ten cent per share profit and then buy something else. I thought this was how to make money. Then, the stock that I sold would eventually go up 50% and the next stock I bought went down and I lost all of my profits. It as mentally draining, and detrimental to my account value as well. Once I realized that her had to be a better way, I started to dial in on the only thing that determined my profit and loss, price. I started to learn about technical trading, and then realized that it can be it’s own never ending journey with dozens of indicators, oscillators, trend lines and systems and started to reduce that down.
I started to make money trading when I simplified it down. I use a few key moving averages, a data screener , and a few indicators. Investing and trading can be one of the most intellectually rewarding and financially profitable endeavors that one can undertake – when done correctly. Unfortunately, there is often a very long learning process and losses along the way. Some are able to persevere and find their way through to the side of profitability, but many do not. Hopefully this piece will provide some insights on how to reduce emotional involvement and increase profitability.