Innovative Trading - Day Trading

The normal work ethic of time, effort and reward that is common in most job situations does not apply in the markets. For example, a factory worker putting in overtime and working extra hours is rewarded with more money. As a general rule, the greater the effort we put in, the greater the reward we expect. However, no such work ethic exists with the markets. A trader can spend years creating a trading system, only to see his equity wiped out in a matter of days. A trader, however, may quickly develop a simple system and reap huge profits. Whether we acknowledge it or not, we normally believe that we deserve money under certain conditions where we have to expend a certain amount of effort to get our reward. For example, an investor sitting on a big profit feels he does not deserve it, and therefore tries to snatch it. When a trader loses, he feels that his input in terms of effort means he deserves a reward and he holds his loss. His subconscious mind constantly equates time and effort with reward, and this affects his objective judgment.

There is unlimited profit and loss potential. This is the one characteristic that brings out the worst emotions in traders and causes them to lose. They simply cannot cope with the unlimitedness of the markets’ movements. This “unlimitedness” and the massive leverage available cause traders to create risk by their emotional desire to avoid it. This may sound illogical until we examine how an investor’s emotions interact with his perception of risk reward.

Consider the following:
If making money is important to you, as it is to most people, you will have difficulty taking a small loss. If you bear in mind a trader’s self esteem and the fact that money is on the line, you will appreciate the psychological turmoil this can cause. Profits, on the other hand, are just as difficult to cope with. When a large profit occurs, he gets excited, and the bigger the profit becomes the harder it is to resist the temptation to take it now. However, profits need to be run to cover inevitable losses. In their efforts to avoid risk, investors actually end up creating it.

Consider the following psychological test:
A group of people are given the following choice over a number of trades: A 75% chance to win $1,000 with a 25% chance of getting nothing, or a sure $700. Four out of five subjects take the second choice, even after it is explained to them that the first choice leads to a $750 gain over time.

Another test gives people the following option; a sure loss of $700 or a 75% chance of losing 1,000 and a 25% chance of losing nothing. Three out of four took the second choice, condemning them to lose 50 more than they have to. So, in trying to avoid risk, investors create it.

Emotion causes most traders to act in a way that will lead to their ultimate demise. They prefer a sure gain, however small, to a logically based speculation to seek a large profit. On the other hand, they actually seek risk in the realms of losses. They let losses run to avoid taking a small loss and, by doing so, they create greater risk for themselves. They expose themselves to bigger losses when they could have had a certain small loss.

THE PARTICIPANTS

Wall Street, the famous financial area of New York, is named after a wall built in Manhattan in the early settlement days, to stop animals wandering. Today the farming connection lives on in the language of the brokers; namely bulls, bears, hogs and sheep.

Bulls are buyers: a bull fights by striking upwards with his horns. A bear, on the other hand, fights by striking with his paws. Bulls look up, bears look down, and the price is a constant fight between the two. So, who are the hogs and sheep? These are the majority of investors trampled underfoot. A hog is greedy and takes positions that are too large and is wiped out by small, adverse moves, or holds profits for too long in the hope that prices will go on for ever. Sheep are passive and fearful followers of the media, gurus, brokers and friends. They bleat at everyone when they lose, and cannot accept they were responsible.

The farming analogy is very close to what happens in reality. Only strong bulls and bears make money. The crowd-following characteristics of the sheep, combined with the greed of the hog, characterises most losing traders in the market.

DESTRUCTIVE EMOTIONS

There are four that are really important in investing: greed, fear, hope and pride.

Greed:
Greedy investors tend to be over-confident and want to make as much money as they can in a short period of time. They want big profits and they want them now. The desire to make money, however, is in many instances unrealistic. If, for example, I gave you a small vegetable patch and told you to feed your family from it, you would probably think about it logically and deduce that you had insufficient resources at your disposal to achieve the aim. Contrast this with the amount of people I speak to who want to invest $5,000 in a commodity account, and earn a living from it and retire from their job. The chance of achieving their desire is almost nil, but over confidence and desire overcome logic and objective thinking.

Fear:
All people fear losing money, worrisome news in relation to their investments and savings stimulates more fear. Fear then spreads; a fearful man’s psychology is contagious. If people around us are fearful, so are we. If we have suffered fear in the past, we retain all our past experiences in our subconscious mind. Finally we have the fear of losing. Also, if we see other people making money, we want to be in on the action as well.

Hope:
This is defined as the expectation of something desired. However, investment decision making should not be based purely on desire, but on a rational assessment of the facts. When a trader loses he hopes that things will get better when he really should be being objective. If you read the great traders, you will constantly see them refer to Hope and Fear and their destructive power.

“Hope and fear: I have written about this often in my books, and I feel I cannot repeat it too often. The average man or woman buys commodities because they hope they will go up or because somebody advises them they will go up. This is the most dangerous thing to do, never trade on hope. Hope wrecks more people than anything else. Face the facts and when you trade, trade on facts, eliminating hope.”

“Fear causes many losses. People sell out because they fear commodities are going lower, but they often wait until the decline has run its course and sell near the bottom ... never make a trade on fear.” --W.D. Gann

“The successful trader has to fight ... two deep-seated instincts, instead of hoping he must fear, instead of fearing he must hope. He must fear that his loss may develop into a much bigger loss, and hope that his profit may become a big profit. It is absolutely wrong to gamble in stocks the way the average man does.”

“The speculator’s chief enemies are always boring from within. It is inseparable from human nature to hope and to fear.” --Jesse Livermore

After greed the average speculator, to achieve his desire, falls victim to both hope and fear and ultimately loses his money.

Pride:
“Pride of opinion has been responsible for the downfall of more men on Wall Street than any other factor.” --Charles Dow

Pride of opinion is a characteristic of losing traders that have not been able to see their inner selves; they do not know their own strengths and weaknesses. They do not understand themselves and their emotions. Pride is simply stubbornness and the inability to admit a mistake. Any trader who insists on holding a viewpoint in total contradiction to what is actually going on around him for no other reason that he cannot admit he is wrong, will meet the financial disaster. Price can be a direct reflection of the preceding emotions. The market is all-powerful, it moves regardless of any man. You can do nothing to influence where it is going and you cannot control its behaviour. When you compete in the market only you can be wrong, and it can never be the other way around. Although the market is a harsh environment and does not care about your welfare, it is not, as many losing traders think, out to punish you.

Consider an analogy with the sea. A sailor cannot control the sea but he can control himself, and in doing so he can earn a reward. A skilled mariner knows that the ocean needs to be respected, but he does not fear it. He develops skills and discipline to help him benefit from it. By using his acquired skills, no matter what the weather, the sailor is confident of getting into port without harm, and earning his living. An ocean is like the markets, it can make a man money or he can drown in it, the choice is there for each individual.

Just as mariners follow rules to navigate from A to B, so must a trader follow rules to keep him from being sidetracked. The rules that I will outline are not new and they are not original. They will, however, help you reach your goal of consistent profits. If you do not have rules and guideline you will fall victim to outside influences and be influenced by your emotions, your objectivity will be lost and so too will your money.