The early bird gets the worm, but….

It’s the second mouse that gets the cheese!

There are times my trading coach tells me that I’m getting into trades too late.  Contrary to that, I think I’m often getting into my trades too early!  I feel like the first mouse who gets trapped, only to see the second mouse happily waltz by and take the cheese!

What does that mean?

Spotting turns using Elliott Waves can be tricky sometimes, especially when wave counts aren’t very clear and I mistake a wave v of 3, for a full 5 wave completion and am aiming to trade the turn around.  That’s trying to be the early bird – being a tad too eager.

Sometimes it’s better to be patient, and let price confirm the direction.  While it is not in my forecasts, I was also watching the USDCHF and happily counting the waves.  I’m anticipating a 5 waves completion soon but I entered short too early and price had stopped me out.

USDCHF 15min

Look at that beautiful pin bar which just appeared and is beckoning me to take another short trade after having stopped out.  Psychologically, I’m more reserved now after being stopped out, but everything within me tells me to look for that turn around. And I have to ask myself “Is this a revenge trade?” and “Do I have a biased view and am I ignored certain evidences because of that bias?”

There are many times where the price hits my stop loss and promptly reverses in my “favor” and even hits my original take profit level.  It feels like the market is intentionally taunting me. If you have been trading for awhile, I’m sure you have experienced the same thing.

At the end of the day, I think we’ll never really know. The main thing is, if you have a low-risk trading idea - plan your trade and trade your plan.  Losses are part of the game.  Be willing to take losses, and always be willing to re-enter the market if you get another signal. Discipline, and good money management.

The Big List of Behavioral Biases

 

From BusinessInsider.com’s article on “61 Behavioral Biases That Screw Up The Way You Think”, I decided to take a look at it’s source: Tim Richard's Psy-Fi Blog.  I found that these were actually expanded from a list of “slightly odd behaviours in the sphere of investment”.

As a part of trading psychology, and a way to better understand ourselves as traders. I think these articles are a good read. And it’s good to identify some of our own biases and guard against them.

For the full article, click on the links above, and here are my thoughts on some of these Biases.

Self-Enhancing Transmission Bias: people tell others about their successes more often than their failures, and their listeners don't take account of this.

Often times when we speak to traders, they will share their winning trades with you.  It is important to get the full picture and see both winning and losing trades.  And often times, there are more things to learn from losing trades than winning ones.  The goal is, naturally, to learn from mistakes and not make them again.

The next time someone shares their winning trade with you, ask (nicely) about all the trades the person had for the week or month.

Choice Overload: too much choice makes us indecisive.

Some people think that trading many currency pairs in many timeframes using many trading strategies is the best way to be profitable. Contrary to that, successful trades often focus on a few pairs of currencies, using only a few profitable strategies. Having too many strategies (and too many indicators in one) will likely only confuse you.

Sometimes, Less is More.

Bias Blind Spot: we agree that everyone else is biased, but not ourselves

I’m guilty of this one, and it’s important to recognize that we always have a bias. In fact, when you trade, you always have a bullish or bearish bias, why else would you trade in that direction?  But it’s important to recognize that it’s a bias, not a fact, that you are trading.

 

Confirmation Bias: we interpret evidence to support our prior beliefs and, if all else fails, we ignore evidence that contradicts it

Every trader has done this before – Ignore contradictory signals because he has already entered a trade.  And again, this bias often only becomes clear after the trade his a stop and becomes reality.  Here is where an opportunity to have a smaller loss is ignored, in favor or hope that other evidence which supports your trade will prevail.

 

Gambler's Fallacy: the mistaken belief that a run of specific results in a random process must revert.

This is the thought process behind the Martingale Money Management Strategy.  “I’ve lost 5 times in a row, the next one will be a win!” That’s the reason that gambles double their bets each time they lose in a bid to win back the losses.  Give it an unlimited number of tries, and you will have a win simply due to randomness / probability.  However, you must first have very deep pockets as doubling up each time will quickly bankrupt you.

If you risked 1% of your account for your first trade, and doubled up each time you made a loss. In a string of 5 losses, you would have lost 24% of your account!  It gets worse! In your 7th string of losses, you would have lost 96% of your entire account, and a string of 7 losses is not uncommon in trading!

 

And there you are! Remember, Psychology is a key pillar in trading!

Congitive Biases

In a previous post, I talked about the Trend Volatility Line (TVL), one of the gems I gleaned from the Gold & Forex Masterclass 2009. Here's another interesting tidbit that I didn't have the time to write about until now - Congitive Biases.

One of the most important aspects (that I'm still working on) for trading, is self-awareness. Naturally, this means that one should also be aware of various cognitive biases that influences one's judgement and decision making. Here are some of the biases that Mr William Purpura shared during the masterclass. For some of these, I've taken the liberty to do a little desktop research to elaborate alittle more on some of these biases.

Sunk-Cost Bias: Acting to justify money already spent.
Sunk-Cost Bias doesn't just influence our trading decisions, it can affect most of any decision we have made. For example, if I had already started on a course of study, and about 20% through the course I realise that it was the wrong course to take. I might continue with the course and pay for the rest of the course even though it is not what is useful, that is called sunk-cost bias. One good way to mitigate such bias is "Zero Based Thinking". As Brian Tracy describes, you can help yourself by asking “Is there anything in my life that, knowing what I now know, I would not start up again today, if I had to do it over?”. For trading, you can ask yourself "IS there any trade that, knowing what I now know, I would not enter into if I had to do it over?" If there are such trades, and you refuse to take a loss, you know that you are under the influence of sunk-cost bias.

Anchoring Bias (or focalism): Focusing on an anchor rather than market action.
This is what Wiki says: "Anchoring or focalism is a cognitive bias that describes the common human tendency to rely too heavily, or "anchor," on one trait or piece of information when making decisions." My interpretation of this is that if one focuses only on one aspect of trading, instead of the trading system as a whole (You do have a trading system right???) then you have subjected yourself to Anchoring Bias. How to overcome this? I guess... write down your trading plan and stick to it!

Confirmation Bias: The tendency to search for and interpret information that confirms our preconceptions.
I think this is fairly common for many traders. When you take a particular position, say LONG EURUSD, and tend to look for news or price actions that supports that trade, and totally ignore all other indicators or news....

Outcome Bias: Valuing a decision based on its outcome.
This is a good one to remember whenever you make a trade according to your system, but it turns out to be a loss. The book "Fooled by Randomness" touches on this topic, and actually I highly recommend reading that book. Basically, imagine that there was a bet where you had 90% chance of winning $100, and 10% of losing $50. You took that bet and you lost $50. Does that mean that the decision was bad? The expectancy of that bet was positive ($85), so the decision to take it was a good one, regardless of its outcome.

Bandwagon Effect: Believing something because the crowd does.

Loss Aversion Bias: Natural tendency to prefer to avoid loss over acquiring gains.

Disposition Bias: The tendency to lock in gains and let losses run.

Five Fatal Flaws of Trading

Five Fatal Flaws of Trading
June 25, 2009

By Jeffrey Kennedy

Close to ninety percent of all traders lose money. The remaining ten percent somehow manage to either break even or even turn a profit – and more importantly, do it consistently. How do they do that?

That's an age-old question. While there is no magic formula, one of Elliott Wave International's senior instructors Jeffrey Kennedy has identified five fundamental flaws that, in his opinion, stop most traders from being consistently successful.

We don't claim to have found The Holy Grail of trading here, but sometimes a single idea can change a person's life. Maybe you'll find one in Jeffrey's take on trading? We sincerely hope so.

The following is an excerpt from Jeffrey Kennedy’s Trader’s Classroom Collection. For a limited time, Elliott Wave International is offering Jeffrey Kennedy’s report, How
to Use Bar Patterns to Spot Trade Setups, free.

Why Do Traders Lose?

If you’ve been trading for a long time, you no doubt have felt that a monstrous, invisible hand sometimes reaches into your trading account and takes out money. It doesn’t seem to matter how many books you buy, how many seminars you attend or how many hours you spend analyzing price charts, you just can’t seem to prevent that invisible hand from depleting your trading account funds.

Which brings us to the question: Why do traders lose? Or maybe we should ask, 'How do you stop the Hand?' Whether you are a seasoned professional or just thinking about opening your first trading account, the ability to stop the Hand is proportional to how well you understand and overcome the Five Fatal Flaws of trading. For each fatal flaw represents a finger on the invisible hand that wreaks havoc with your trading account.

Fatal Flaw No. 1 – Lack of Methodology

If you aim to be a consistently successful trader, then you must have a defined trading methodology, which is simply a clear and concise way of looking at markets. Guessing or going by gut instinct won’t work over the long run. If you don’t have a defined trading methodology, then you don’t have a way to know what constitutes a buy or sell signal. Moreover, you can’t even consistently correctly identify the trend.

How to overcome this fatal flaw? Answer: Write down your methodology. Define in writing what your analytical tools are and, more importantly, how you use them. It doesn’t matter whether you use the Wave Principle, Point and Figure charts, Stochastics, RSI or a combination of all of the above. What does matter is that you actually take the effort to define it (i.e., what constitutes a buy, a sell, your trailing stop and instructions on exiting a position). And the best hint I can give you regarding developing a defined trading methodology is this: If you can’t fit it on the back of a business card, it’s probably too complicated.


Fatal Flaw No. 2 – Lack of Discipline

When you have clearly outlined and identified your trading methodology, then you must have the discipline to follow your system. A Lack of Discipline in this regard is the second fatal flaw. If the way you view a price chart or evaluate a potential trade setup is different from how you did it a month ago, then you have either not identified your methodology or you lack the discipline to follow the methodology you have identified. The formula for success is to consistently apply a proven methodology. So the best advice I can give you to overcome a lack of discipline is to define a trading methodology that works best for you and follow it religiously.

Fatal Flaw No. 3 – Unrealistic Expectations

Between you and me, nothing makes me angrier than those commercials that say something like, "...$5,000 properly positioned in Natural Gas can give you returns of over $40,000..." Advertisements like this are a disservice to the financial industry as a whole and end up costing uneducated investors a lot more than $5,000. In addition, they help to create the third fatal flaw: Unrealistic Expectations.

Yes, it is possible to experience above-average returns trading your own account. However, it’s difficult to do it without taking on above-average risk. So what is a realistic return to shoot for in your first year as a trader – 50%, 100%, 200%? Whoa, let’s rein in those unrealistic expectations. In my opinion, the goal for every trader their first year out should be not to lose money. In other words, shoot for a 0% return your first year. If you can manage that, then
in year two, try to beat the Dow or the S&P. These goals may not be flashy but they are realistic, and if you can learn to live with them – and achieve them – you will fend off the Hand.

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For a limited time, Elliott Wave International is offering Jeffrey Kennedy’s report, How to Use Bar Patterns to Spot Trade Setups, free.

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Fatal Flaw No. 4 – Lack of Patience

The fourth finger of the invisible hand that robs your trading account is Lack of Patience. I forget where, but I once read that markets trend only 20% of the time, and, from my experience, I would say that this is an accurate statement.

So think about it, the other 80% of the time the markets are not trending in one clear direction.

That may explain why I believe that for any given time frame, there are only two or three really good trading opportunities. For example, if you’re a long-term trader, there are typically only two or three compelling tradable moves in a market during any given year. Similarly, if you are a short-term trader, there are only two or three high-quality trade setups in a given week.

All too often, because trading is inherently exciting (and anything involving money usually is exciting), it’s easy to feel like you’re missing the party if you don’t trade a lot. As a result, you start taking trade setups of lesser and lesser quality and begin to over-trade.

How do you overcome this lack of patience? The advice I have found to be most valuable is to remind yourself that every week, there is another trade-of-the-year. In other words, don’t worry about missing an opportunity today, because there will be another one tomorrow, next week and next month ... I promise.

I remember a line from a movie (either Sergeant York with Gary Cooper or The Patriot with Mel Gibson) in which one character gives advice to another on how to shoot a rifle: 'Aim small, miss small.' I offer the same advice in this new context. To aim small requires patience. So be patient, and you’ll miss small."

Fatal Flaw No. 5 – Lack of Money Management

The final fatal flaw to overcome as a trader is a Lack of Money Management, and this topic deserves more than just a few paragraphs, because money management encompasses risk/reward analysis, probability of success and failure, protective stops and so much more. Even so, I would like to address the subject of money management with a focus on risk as a function of portfolio size.

Now the big boys (i.e., the professional traders) tend to limit their risk on any given position to 1% - 3% of their portfolio. If we apply this rule to ourselves, then for every $5,000 we have in our trading account, we can risk only $50-$150 on any given trade. Stocks might be a little different, but a $50 stop in Corn, which is one point, is simply too tight a stop, especially when the 10-day average trading range in Corn recently has been more than 10 points. A more plausible stop might be five points or 10, in which case, depending on what percentage of your total portfolio you want to risk, you would need an account size between $15,000 and $50,000.

Simply put, I believe that many traders begin to trade either under-funded or without sufficient capital in their trading account to trade the markets they choose to trade. And that doesn’t even address the size that they trade (i.e., multiple contracts).

To overcome this fatal flaw, let me expand on the logic from the 'aim small, miss small' movie line. If you have a small trading account, then trade small. You can accomplish this by trading fewer contracts, or trading e-mini contracts or even stocks. Bottom line, on your way to becoming a consistently successful trader, you must realize that one key is longevity.
If your risk on any given position is relatively small, then you can weather the rough spots. Conversely, if you risk 25% of your portfolio on each trade, after four consecutive losers, you’re out all together.

Break the Hand’s Grip

Trading successfully is not easy. It’s hard work ... damn hard. And if anyone leads you to believe otherwise, run the other way, and fast. But this hard work can be rewarding, above-average gains are possible and the sense of satisfaction one feels after a few nice trades is absolutely priceless. To get to that point, though, you must first break the fingers of the Hand that is holding you back and stealing money from your trading account. I can guarantee that if you attend to the five fatal flaws I’ve outlined, you won’t be caught red-handed stealing from your own account.

For more information on trading successfully, visit Elliott Wave International to download Jeffrey Kennedy’s free report, How to Use Bar Patterns to Spot Trade Setups.

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Jeffrey Kennedy is the Chief Commodity Analyst at Elliott Wave International (EWI). With more than 15 years of experience as a technical analyst, he writes and edits Futures Junctures, EWI's premier commodity forecasting package.

Mind Games for Trading

One of my colleagues once conducted an informal creativity session as part of a qualification he is studying for. And there was one mind-trick that I found particularly interesting. Its much easier to experience it, than it is to explain it. Take some time to actually do the exercise and don't read past what you are supposed to do. So here goes.

For the first part of the exercise: For 2 minutes, think about as many ways you can use a paperclip. e.g. Ear-rings, hook...etc. See how many you can come up with.

Now, do not proceed until you have taken 2 minutes to do the first part.

For the second part of the exercise: For 2 minutes, think about as many was you can about what a paperclip cannot be used for.

What happened? If you were like me and many others, you would have found many other ways you could use the paperclip for! Interesting isn't it?

I'm going to apply this little negation technique to trading, and actually, its not really new to the trading world. Many of us look for reasons to trade, and many times our mind distorts our reality, and we "see" things that aren't really there. Sometimes, we end up fabricating what we want to see. And admitted so... that's also a challenge I face.

So if we apply the little negation technique, what happens? The negation technique can be used to eliminate some of these badly thought-through trades. Instead of looking for reasons to trade, look for reasons not to. If you can find 3-5 reasons not to trade, then perhaps its more prudent not to. If you can't find any reasons not to trade, then perhaps there you have a good opportunity.

Another way some people do it is to list the reasons to trade, and reasons not to trade. Then depending on which side has more reasons, decide if its a good opportunity to trade.

Of course, when it comes to trading, its a different environment from brainstorming. In trading, you have much less time to react. Weigh your options for too long, and you made find that the window of opportunity has already closed. Nonetheless, its sometimes a useful mental exercise to go through to keep ourselves in check.

What do you think?