Tuesday, July 14, 2009

The role of emotion in trading...

THE TALE OF TWO TRADERS

Our first trader is Ned. Ned is an off-the-floor trader who day trades the S&P 500 Futures. He’s been trying to be consistently successful for the last six months. Unfortunately, it hasn’t worked out very well. But it’s not because of his methods that he’s having so much trouble. No, the main reason Ned is not making the kind of money he wants is because he cannot control his emotions and consistently act in his own best interest.

From the very beginning, Ned was confident he would be successful day trading the S&P’s. He’d been very successful in his previous business. Ned owned a retail printing company and he’d learned to make good sound business decisions that helped him become very successful. He almost never made any major mistakes that were detrimental to the business. In fact, in over the nine years he owned the company, he really prided himself in always looking at the big picture and keeping his business moving forward. On the rare occasion when something did go wrong, Ned worked at lightening speed to fix the problem, and many times he turned the crisis into an opportunity.

Because of the smart decisions he’d often made, Ned was sure he could carry this into his new career of commodity trading. At least that’s what he thought would happen. So, when Ned received a generous offer from a corporation to buy his printing company, he decided this might be the time to take the money and run.

It wasn’t that difficult for him to decide to sell. He definitely loved having his own business and, of course, it was that much more rewarding because he was successful. But for the last two years, he’d been so busy that he was working about 65-70 hours a week. That left very little time for him to spend with his family. This made the decision to sell very easy for him.

Another thing that made Ned’s decision easy was that he wanted to try a new business. He had learned as much as he could about commodity trading. He’d read as many books and magazines he could get his hands on. He definitely thought he could transfer his successful business practices to commodity trading. Thus, he could trade from home and be able to spend a lot more time with his family. He was quite confident he would be a success in this endeavor too. Boy, was he in for a surprise.

The second trader in our story is James. James also wanted to day trade the S&P 500 Futures. His background is a little different than Ned’s. James has spent the last four years working at the Chicago Mercantile Exchange where the S&P 500 Futures are traded. But James was not a trader at the CME. He had basically worked his way up from a runner. He was working for a retail commodity firm as a phone clerk. His job was to put in buy and sell orders for customers using hand signals.

From the first day James had started working at the exchange, he had always wanted to be a trader. He knew he didn’t have enough money to buy a seat on the exchange (which costs about $200,000). He thought his best chance to become a trader was to learn all he could from the various floor traders and other people on the trading floor, and then trade from off-the-floor where he wouldn’t have to own a seat.

James spent as much time as possible trying to learn how people in the commodity business made money. He was sure there had to be some very specific techniques only the real successful people were using. He certainly knew, like everybody else, that 80-90% of the people lost money trading. He was determined to learn what he needed to know so he could be successful when he started trading from off-the-floor. He wanted to start trading as soon as possible.

James made a point of trying to meet as many successful traders (both on and off-thefloor) as he could. He was lucky enough to be exposed to all these successful people on the floor and in the various offices at the Chicago Mercantile Exchange. He thought if he could figure out exactly what the successful traders were doing, he could model his own trading off of them. He spent every free moment talking to the various traders that he’d met and tried to find out the secrets of their success.

He learned a lot. He learned all kinds of different technical methods that the various floor traders and off-the-floor traders used. James had never traded a futures contract in his life. But the more he talked to different traders, the more his confidence grew. He was sure with the experience he was getting he would surely be a successful off-the-floor trader. But he still needed one more important lesson.

Ned began trading. He started with $15,000 in his account and decided he would only trade one contract at a time until he was sure he had the hang of things. Things actually started off fairly well for Ned. His first trade made 320 points ($800 before commission charges). Obviously, Ned felt very good about his start. Unfortunately, things went downhill from there.

On his next four trades, he lost on all four. The problem was that Ned had good profits on two of those four trades, but he failed to take them because he would look for a lot more than the market was offering. So, in his first week, instead of making a small profit or breaking even with the four trades, he ended up losing the original $800 and even another $1,200 more. This was very frustrating and confusing to Ned. He obviously needed to do a lot better if he was going to be successful in this business. But not to worry, it was only the first week. He certainly didn’t make a fortune his first week in the printing business.

The next week started basically the same as the first. His first trade (on Monday) was another nice winner of 280 points ($700), but the downhill slide started again. Ned did his next trade on Tuesday of that week. He got in and the market went his way about 120 points. Ned knew if he could make 200 points on this trade, he could get back to even. So that is what he decided to look for in this trade. He put an order to get him out of the market with a 200-point profit. The problem is the market only went 150 points his way and Ned did not trail his stop order to lock in a profit or at least move his stop to break-even. He really wanted to get that 200-point profit so he could be even, but the market came all the way back and not only took away the 150 points in profit it was offering, but also took away the amount he was originally risking when the market hit his stop order. Ned ended up losing $400 on this trade.

Now Ned was very frustrated. Sitting at his desk, he considered throwing his empty ceramic coffee cup across the room at the wall. Luckily he resisted doing this as the thought of getting the broom and dustpan to pick up broken glass didn’t seem like it would fix his losing trades. Nevertheless, Ned was extremely frustrated and needed to come up with a way to fix things.

“One of the most important things you can do is to set a daily, weekly, and monthly goal for yourself.” James was getting some advice from one of the most successful off-the-floor traders he knew. This particular off-the-floor trader had made over half a million dollars a year for the last four years, so James knew he was getting good advice.

“The way to be successful is to have measurable goals for yourself”, the off-the-floor trader continued, “and then you have to continually visualize yourself reaching those goals.” James understood about setting goals, but he really wasn’t sure what the visualization part meant. He knew he would need to find out what that was all about.

James continued to talk to as many successful traders as he could. They all seemed to say the same things. Goal setting was extremely important. Just trying to make money each day (without a goal) was a road to failure. It seemed like almost every trader James talked with really stressed the daily goal setting idea. In fact, it seemed the more successful the trader the more they stressed goal setting. James made a strong mental note that if he were to be successful, he would need to have very specific goals as to how much he wanted to make each day, as well as how much he was willing to lose.

James found another fairly successful floor trader named Bob. Bob was nice enough to give James some advice. “Yes I agree with you, you do need to set specific goals”, Bob said, “but I would say just as important, you must visualize your success each and every day. You must see yourself very clearly as a successful trader. If you can’t see yourself in your mind’s eye as a success, there is no chance you will become successful.”

Bob told James about a book he should definitely read. “Get the book Psycho- Cybernetics, it will tell you everything you need to know about visualizing your success. It’s the same method professional athletes use, but it’s really no different in our business. To be a successful trader, you must see yourself as a successful trader, even if it’s not true yet.”

James did not hesitate following Bob’s advice. He went out and bought a copy of Psycho-Cybernetics. He began studying immediately. James learned the different visualization techniques and began to use them on a daily basis. Even though he had yet to start trading, through his visualizations, he had already started to see himself (in his mind’s eye) as a successful off-the-floor trader. This would play a big part of why James would become successful.

Ned thought about the difficult time he was having. He needed to come up with a way to get better results. He thought that maybe the indicators and methods he was using were the problem. Ned decided to find some new methods to trade with. He bought various books and courses on how to trade the S&P 500. Each time he went through these materials, he was sure he would start having better results. The ideas and examples seemed to make a lot of sense to him.

Ned decided to use some of these new methods in his trading and get rid of the old methods he was using. He was sure it was the techniques he was using that were causing him to lose money. Unfortunately, it was not his methods that were causing his losses.

Ned started using these new methods to trade and was actually doing quite well for a couple of days, but then he made a serious mistake. He had a losing trade and got very angry. He had gotten stopped out of a position that he was sure was going to be a big winner. As soon as he got stopped out, the market went his way almost 600 points in 15 minutes. Ned decided he wasn’t going to let the market take his money. He proceeded to do three more trades. He let his emotions get the best of him and made the near fatal mistake of trading without stop orders.

At the end of the day, Ned had lost over $7,000. His broker had forced him to get out of a position that was over 1000 points against him. Ned wanted to stay in the position overnight to see if it would recover. Ned swore at his broker before he hung up on him. This time Ned did throw his coffee cup across the room. It shattered against the bookcase and made a deafening crash. His wife ran into his office to see what was wrong.

“What happened?” she asked, “What was that noise?” Ned didn’t need to answer as she looked over at the bookcase and saw all the broken glass on the floor. She told Ned she would get the broom.

“JUST LEAVE IT!!!!” Ned snapped at his wife. He couldn’t remember ever using a tone like that with the woman he planned on spending the rest of his life with. Without uttering another word, she walked out of his office. Ten minutes ago, Ned thought he couldn’t ever feel worse than he felt at that time. Now he felt worse.

James gave his two-week notice to his employer and began to get set up for his off-thefloor trading career. He’d gotten his real-time quotes and charts set up. He had opened a trading account and, in about two weeks, he would be ready to give his endeavor a try. James continued to visualize himself reaching his daily, weekly, and monthly goals. In his mind’s eye, he kept seeing himself finding opportunities in the market and taking advantage of them. He kept seeing himself trailing his stop orders to lock in profits and avoid having winning trades turn into losers. He kept seeing these images in his mind until they became crystal clear.

He visualized his equity continuing to rise in his account. Not at lightening speed, but more at a slow steady rate. He felt if he could just get himself to make $250 each day, it would be a great way to start. He realized that trying to make thousands of dollars each and every day was just not realistic for him.

James began trading on Monday. He had his goal in mind. He had spent a lot of time over the last couple of months visualizing what he would do and how he would react in as many possible situations as he could. In fact, he saw these things in his mind so often that he felt like they had actually happened for real. That really gave James a lot of confidence. Even though he’d not ever traded before, he felt like he had traded thousands of times.

It showed in his results. James’ very first day was a success. He’d made only one trade and made $275. He considered trading more, but then remembered that his goal was to try and make $250 a day, and doing another trade could make him more money, but it could also cost him the money he’d already made. He decided to just paper trade the rest of the day and keep his attained goal intact.

One of the most important lessons James had learned from other traders he knew (both on and off-the-floor) was the reason people were successful in this business was because they were able to find the ability to act in their own best interest. He knew that hoping and praying the market would move in a certain direction certainly had no bearing on whether the market actually did move in that direction. No, the thing that made people successful at trading was when they did what was in their best interest to get winning trades and avoid losing trades (or at least to keep the losing trades small).

For instance, James may have wanted to make 250 points on his next trade, but if most the market is offering at the time is only 150 points, then it’s obvious no matter how much you want 250 points in this trade, the most you can possibly attain is 150 points (and probably not even that much). You can ’t force the market to do something. You can’t control the market to do what you want. So you must control yourself to do what is in your best interest.

Because of James’ exposure to so many traders who understood that idea, it wasn’t very difficult for him to act that way too. It wasn’t easy, but it was probably easier for him than it would be for most others. Because of that fact, James’ trading did very well over the next several weeks. He consistently made between $600-$800 a week for his first month.

Sure, just like anybody, James had some losing trades and made some mistakes. When James did have a losing trade, he would visualize in his mind what he could have done differently to make the trade a success or to make the loss even less. He would see in his mind what he should do the next time the situation presents itself. He would do this with his winning trades also. He would think of ways he could have managed the trade better, and then see that picture in his mind over and over again.

Consistently doing these things helped James to make over $15,000 in his first six months of trading. He kept his goal clearly in mind and did what was in his best interest to keep moving towards the goal. Did it work perfectly? No, but it worked well enough to get him on pace to making the same amount of money he was making at his old job. But now he was doing it the way he wanted to do it, by trading for a living from home.

Ned was not as lucky as James. He was not exposed to people who could teach him the lessons that James had learned. Because of that, Ned decided that trading was not going to work out for him. He’s now back at the printing business again. He still dreams of trading. He probably could be successful at it if he only learned to act in his own best interest. But he never did.

No comments:

Post a Comment