Friday, July 20, 2012
The hard road to consistency I - Overtrading
The trouble with trading is that you are in a position to do whatever you want and need to struggle to develop the discipline not to do things that hurt you. This is exactly the opposite from the real world where you are in a position to do very few things and have to struggle to do things you want to do.
You will learn very quickly that doing everything that comes to your mind leads quickly to ruin. The only way out is to learn not to do things. Your focus needs to change to stop doing things that cost you money even though they work some of the time.
In trading nothing is guaranteed. No setup is guaranteed to work every single time and even the best setups can have a repeated sequence of many losses. Everything is a probability and probability works only with a large number of samples. Even a 50% setup should be expected to see at least 6 consecutive losers in 100 attempts. (Go ahead, toss a coin 100 times).
Despite having a profitable system, many traders fail and this is because they are unable to follow their own rules. A trader needs to figure out what habits are damaging their trading and root them out.
The most dangerous bad habit is over-trading. What over-trading is depends on your style of trading. If your goal is to trade the 3 to 5 large swings of the day, then any day over 10 trades is probably over-trading. If you are a scalper who wants to take 10 trades a day, 20 may not be that bad but 40 certainly is. The best measure of overtrading is a poor win/trade ratio. 2 points from one trade is decent, 2 points from 20 trades is not.
Overtrading usually is caused by the trader reacting poorly (emotionally) to a loss. There are two kinds of reactions to a lost trade: Retrying and flip-flopping. A trader who has decided the market is going down will continue to short the market over and over, regardless of stop-outs. He thinks he is right about the direction of the market but incorrect about timing or stop size. The next time has to work!
The flip-flopper is far worse. He will go long if stopped out of a short trade and vice-versa. If a great long setup was stopped out, then the market certainly should drop, right? (Answer: wrong. See b14)
The correct way to react on a loss is to look at the market objectively and enter only if there is an extremely good reason. A trader susceptible to overtrading should just sit out a few bars even if there appears to be a good reason to re-enter. Usually, if you were stopped out of a good setup, the market probably is in chop and you should not trade for a while.
Wait for the price to move away from the area you were stopped out from or give two swings in opposite directions after the bar that stopped you out. Most traders who enter right away after being stopped out have a state of mind thats a possible combination of disappointment, surprise, sense of urgency and desperation all of which are likely to cloud their judgement. Until you are consistent, stay out until price moves away or gives two more swings after a losing trade.
The mind treats losses like a mini-trauma and needs time to recover. Most losses due to over-trading are caused by poor judgement due to recent loss.
You also need to protect your account from being blown up because you cannot accept to have a losing day and will keep trying to trade your way out of a drawdown. Over traders should have a strict rule regarding the number of losing trades they have per day. If you are in a state of mind that is causing you to lose over and over, trying harder is likely to make it worse, not better.
Understand that your main goal as a trader is to manage risk and once you have crossed a certain number of losing trades, your risk of ending the day with a larger loss is higher if you continue to trade and manage the risk by stopping trading.