April 19, 2011

Learning from the Masters of Risk

Extracted from the book: Inside the Mind of the Turtles, Turtle trader Curtis Faith

 Here are the seven rules great traders use to manage risk and uncertainly. They are

1. Overcome fear
Great traders know that fear can choke our decision process and cause us to avoid taking risks. Fear also can paralyze you when you need to act quickly and decisively to save yourself from danger---the deer-in-the -headlights syndrome. All great traders have mastered their fears adn are able to act decisively when needed.

2. Remain flexible.
As a trader, you never know which stock or which market may make a move. This is the essence of uncertainty. You don't know what is going to happen. When you don't know what is going to happen, the best strategy is to be ready for anything.

3. Take reasoned risks.
Many beginners trade like they are sitting at a Las Vegas craps table. They put too much money at risk, and they trade based on hunches,rumors, or someone else's advice. They take foolish risks. Great traders take reasoned risks. A reasoned risk is more like an educated guess than a roll of the dice. Great traders are not gamblers.

4. Prepare to be wrong
If you don't know what the future will bring and you choose a trade that assumes a particular outcome, you are possibly going to be wrong. Depending on the type of trade, in many cases it can even be more likely that you will lose money than that you will win money. What matters in the end is the total money won and lost, not whether you are right more often than wrong. Great traders are comfortable making decisions when they know they could be wrong.

5. Actively seek reality
As a trader, nothing is more important than an accurate picture of reality. Traders know that their decisions will result in losses. They also know that they need to know about these losses as soon as possible. A focus on what the market actually does, the market's reality, keeps successful traders from burying their heads in the sand and pretending that the world is other than it actually is.

6. Respond quickly to change
Just as important as actively seeking reality and facing that reality is doing something when that reality is not what you wanted, when the uncertain future brings the unhoped-for. When the market moves to price levels that a trader has previously determined would be the place to get out of a trade---by selling what he bought previously, for example---a competent trader will respond quickly and get out, thereby reducing his exposure to continued uncertainty to zero.

7. Focus on decisions, not outcomes
One of the reasons that great traders can so easily reverse course is that they have a more sophisticated view of the meaning of error for decisions made under uncertainty. They understand that the fact that things did not turn out the way they had hoped does not necessarily mean that taking the trade was a mistake. They know that many times good ideas don't work out. The very presence of uncertainty ensures that you will be wrong some of the time. All great traders put trades on for a particular reason, and they take them off for a particular reason too. Great traders focus on the reasons for the trades instead of the outcomes for a few given trades.

November 07, 2010

The Psychology of Trading

Extracted from the book: The Psychology of Trading, Dr Brett Steenbarger

Most of the time the problem with traders is that the frame of mind in which they analyze markets is different from the one in which they are actually making trading decisions. When the author encountered periods of uncertainty and stress, one of his techniques for handling the novel shifts is to temporarily get away from the screen. 

"Behavior patterns are anchored to one's states of mind and body." Once the traders learn the skill of shifting their emotional and physical states, they are free to create and to enact new patterns. The change of emotional and physical state is a powerful strategy for interrupting the impulsive and emotional problem patterns during the volatile periods of price action. 

However, many traders are so afraid of missing a possible market move that they dare not spend time refocusing on their trading plan. They fail to realize the far greater risk of losing sight of their plans and trading haphazardly. 

Your trading plan is your anchor; you most want to utilize it when seas are roiling. The psychological antidote to greed and fear is planfulness, not calm or confidence.

CONCLUSION Late in 2001, the author conducted a survey of the following traders personality traits and coping styles which known as NEO Five Factor Inventory: 

1. Neuroticism ---- the tendency toward negative emotions who reported the greatest problem with their trading 

2. Extraversion --- an outward orientation toward people and life.
3. Openness to experience - a desire for novelty, variety, and risk taking.
4. Agreeableness - the tendency to get along well with others.
5. Conscientiousness -  the capacity to be reliable, steady, and trustworthy.

The findings were eye opening. The traders who reported the greatest success (and who were willing to have me verify their success in case studies) tended to score high in conscientiousness. They were very steady and reliable.
The traders who reported the greatest problems with their trading tended to score high in neuroticism and openness. They were experiencing many negative emotions and tended to use trading for excitement.
The conscientious traders tended to be highly rule-governed in their trading. There was little excitement in their trading. Instead, they very consistently developed their plans and followed them.
The neurotic and risk-taking traders tended to make their decisions impulsively, without prior planning. They tended to revel in telling stories of their great wins and losses.
The survey above drove home one important lesson: Success in trading is related to the ability to stay consistent and plan-driven. Traders fail not because of their emotions, but because their emotions deflect them from their purpose. In developing their rules and systems, the successful traders had found a way to immunize themselves from the emotional effects of market volatility. Indeed, in many respects, the successful traders appeared to be every bit as fearful as the unsuccessful ones. It's just that the fears of the successful traders were not those of drawdown or missing a market move. Rather, they fears deviating from their plans. Dedication to purpose was the cornerstone of their success.

October 21, 2010

Determining General Market Direction

Extracted from the book: Trend Trading for a Living, Thomas K. Carr

Five different types of market conditions
  • Bullish strongly trending
  • Bullish weakly trending
  • Bearish strongly trending
  • Bearish weakly trending
  • Range-bound (or nontrending)

The Focus: It should be on long setups, particularly breakout plays.

Characteristics: Everything goes up, and up a lot, nearly every day. The bulls are completely in control and win every battle with the bears. Making money is easy in a bullish strongly trending market, as long as you have the right entry system. But the drawback is that when this kind of market reaches a top, the sell-off can be quick and harsh and can wipe out months of hard-won gains in a matter of days. So in a strong bull market you must always be careful to play defensively against a possible reversal of momentum.

How to Play It: Here we can say that a bullish strongly trending market is a great market to be in if you are already long. But if you are coming late to the party (and hopefully not too late), your best play is to look for stocks that are breaking out to new highs from periods of consolidation. You must make sure these breakout plays are confirmed by the various technical indicators we use. If price is making a new high but the indicators are not making new highs, then you have bearish divergence and you should move on to another chart.

The Focus: It should be on long setups, particularly pullback plays.

Characteristics: This is a tougher market to trade, since the pullbacks tend to be more frequent, steeper, and
longer-lived. In a weakly trending market, corrections can last a couple of weeks. This can be frustrating if you are sitting on open long positions. Ultimately, the bulls are in control, but it can seem for days on end that the bears have moved in and made themselves right at home. However, this is one of the best markets in which to find great risk/reward scenarios in our setups. Those lengthier pullbacks serve to take a lot of the risk out of a trade, so our stop-loss can be closer to entry, and our exit targets can be that much further away.

How to Play It: Here we can say that a bullish weakly trending market is an ideal market for trend trading. You should find stocks that are showing strong trending action (normally stronger than the general market itself ) but have pulled back to an area of support. This pullback should be confirmed by oversold indicators, and the current daily candlestick should put in a reversal bar of some kind before you consider an entry.