Tuesday, November 9, 2010

Trading

Pure and brutal honesty is hard to find in life. It is even harder to find in trading. Some questions are just so loaded, there really isn't a correct way to answer them truthfully without risk. Does this dress make me look fat? Do you find him/her attractive? Do I look like an idiot? There are the answers you want to give, and then there are the answers you should give.

But what about hopes and dreams? We are told from an early age that with hard work we can accomplish anything we want to. You ask many young children what they want to be when they grow up, and many will say they want to be some type of professional athlete or a superhero or maybe an actor or actress or even a singer. The brutal truth is that many of them just don't have the talent. For many, all the hard work in the world won't replace a lack of natural aptitude. The same can be said for trading. It is a hard and brutal truth.

In the long run, being profitable does determine your longevity as a trader and an investor, but profitability doesn't always make you a good trader, nor does losing money mean you are a terrible trader. The real question some need to ask themselves is, should I be making my own decisions? A separate but similar question is, should I be trading? The first one is a bit easier to tackle, especially if you listen to commercials. I mean, if a talking baby can do it, then anyone can. Heck, this kid still needs a parent to change his diapers, so clearly I have a big advantage over him.

We probably all know people who seem to buy the market at the top, then panic and sell everything at the bottom. A few years pass, and they repeat the process. This doesn't make them bad investors or disqualify them from making their own investment allocations. This makes them investors who need a bit of emotional hand-holding. Their actual investments are often appropriate and even diversified by typical standards, but their emotions cause ill-fated buys and sells. They simply need someone to talk them off the ledge.

Some other long-term investors are plagued by the fear and greed generated by the media. They often consider themselves unlucky or cursed and swear off the market several times in their lives. In the end, they will probably never be able to run their own portfolios. However, they can often construct their holdings as long as they have a crutch to lean upon when times get tough and markets get volatile.

Trading is a different story. How do you tell someone that he or she a terrible trader? Better yet, how do you tell them to stop, or that they shouldn't be trading?

I break "losing" traders into the types: 1.) the "ins/uns," 2.) the inevitable, and 3.) the hopeless.

The first type of losing trader is either inexperienced or uneducated. This is a losing trader with promise. Just because you lose money as a trader, that does not mean you are a bad trader or should quit trading. Often you will hear the term "trader's tuition." This is the cost of experience. Many people, when they are early in their trading careers, will miss entries or be late. They will exit early or miss exits, and have losses instead of gains. Over time, this lack of experience will correct itself. Over that same time, traders can become more educated and strengthened by the experience. If their emotional mind-set is strong and they remain somewhat humble, losing traders can take the experiences and become consistent winners.

Unfortunately, the opposite is also true. Some winning traders are destined to become losers -- traders who are undisciplined but who have gotten lucky early in their careers. Perhaps they have hit the market during a strong bull or bear cycle. Or they are momentum traders riding the train much farther than anyone else in a particular area. Unfortunately, for many of these destined losers, trading is "easy." They enter the market at a time when almost anyone can make money. Not only do they lack the education, they lack the experience of trading in a tough environment. Everything is so easy at the beginning, these traders never develop any discipline or respect for the market. These are the traders whose accounts double or triple in value over the first few years, but they are also the same ones who will inevitably zero out their accounts in months or even days, chasing a bad trade. It is difficult to convince this type of trader to slow down or even quit while he or she is ahead.

The last group is the hardest. These are the hopeless losers. I don't mean it in a derogatory way, but these are traders who have experience, and many have education. However, they don't learn from the experience or the education. They are looking to enforce their will upon the market. This doesn't just apply to the small retail trader. Look at how many professional hedge-fund managers have blown up two, three or even four hedge funds, yet they keep coming back for more and find investors to give them money. These are traders who will never walk away, even though they should. Unfortunately, you will find them everywhere. They make the same mistakes repeatedly. I suppose I should call them insane, since they expect different results from the same strategy.

This last group of traders will often be very oversized in a single position or sector. They will trade beyond their comfort level. Rather than viewing trades in a manner of discipline, they view it in wins and losses. These traders hate losses, like everyone else, but refuse to take them. They are quick to get out of winners, but they do everything they can to get a losing trade back to even. Rather than look for other opportunities to grow their portfolio, "getting back to even" on a specific trade dominates their way of thinking. Their mind-set becomes their reality even if the market disagrees, and rather than adjust to the market, they become angry and frustrated, and that causes them to push positions farther rather than step back to re-examine their mind-set. Kudos to Doug Kass for doing this exact step back to re-examine his thinking. If anyone views this as weakness, shame on you, because this is the sign of a truly good investor and trader. The desire to always be right is what will almost always make this type of trader lose. Many traders looking for the big score and to get rich quick will fall here as well.

If you find yourself constantly trying to justify and rationalize a position you are in and really stretching for answers, yet you continue to expand your position, if you find yourself hoping and praying for a turn in the position just so you can get out even, if you find yourself losing sleep and cursing at the television, media or markets themselves, if you find yourself not understanding what you are doing or why, then it might be time to raise the question, should I be trading?

This isn't an easy article to write, nor can I say I've never been in at least two out of the three categories above, but it needs to be said.

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