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Trading Tips

Maintaining a Position Mindset in a Portfolio

I met with the head of a PhD program yesterday. We had a good discussion of markets and trading, and he brought up a subject that I thought was working a blog post.

This professor talked about how a trader or investor’s mindset can change when going from dealing with individual trades to managing a portfolio of positions. Specifically, he observed how someone who would be very diligent about risk management and following a specific plan of action when managing one specific position could let all that slide when managing one position among many.

For example, a trader whose only position is a long in XYZ stock could be very good about exiting that position on a stop if the market goes against him. If, however, XYZ is only one of ten holdings in a portfolio, the trader might do more rationalizing of letting the position run if the rest of the portfolio is doing well. And you could flip that around to a poorly performing portfolio by dumping positions before they should be sold.

Yes, there are at least some academics who allow for psychological influences on trading decision-making. 🙂

Of course the point is that unless you specifically have a combination of trades that are meant to work together (hedges, pair trades, etc.) then each individual position should be managed based on its own merits.

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Trading Tips

Rogue trading isn’t just an institutional issue

A recent discussion of rogue traders looks to address the reasons why they do what they do.

Those reasons include:

1) The qualities which make them attractive as employees (can thrive in highly competitive environments, remain calm under intense pressure and have the ability to take risks) are the same that lead to rogue trading.

2) They are motivated by money and that  motivation turns to greed, leading them to take greater risks.

3) The traders’ managers benefit from their risky trades in that their bonuses and such are often a function of the groups’ performance.

4) The trader tries to cover up a mistake to protect both their compensation and their reputation.

Now, most readers of this blog probably won’t be in a position to become a rogue trader in the classic sense. That doesn’t mean, though, that these points don’t have value at the individual level.

Consider just one aspect of the rogue trader thing noted above, the part about reputation. If your trading has an ego and reputational element to it – meaning you gain personal and/or social status enhancement from your trading performance – then you are at risk of become a rogue trader in your own way.

Imagine how you would feel being in a position of having made a big bad trade, the result of which would cause a reduction in your social standing. Can you see how you might hide that loss and/or trade your way out of it (usually to very negative effect)?

If we accept the view that the traits that lead to trading success are those which also sow the seeds of rogue trading – which we don’t necessarily have to do, but let me go with this for a moment – then that means all of us who trade the markets have the potential in us to blow up spectacularly. Just one more reason why risk management is such a big deal.

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News & Updates

Sometimes it helps to circle back around

A post on the Rogue Traderette blog came to my attention recently. In it she talks about the Mark Douglas book [easyazon-link asin=”0735201447″]Trading in the Zone[/easyazon-link]. I do not count myself among those who think it’s the best book ever written on trading, as many seem to believe, but I certainly acknowledge it has some good stuff.

RT brings up Douglas’ Five Fundamental Truths:

1.  Anything can happen.

2.  You don’t need to know what’s going to happen next in order to make money.

3.  Wins and losses are random

4.  Your edge is nothing more than a higher probability of one thing happening over another.

5.  Every moment in the market is unique.

I think #1 and #3 are closely related, and even #5 can be said to be along the same line of thinking. The second point is one a great many traders need to take to heart. The fourth one encourages taking a longer-term view, or at least thinking over large numbers of trades.

Perhaps the biggest takeaway from the post is the fact that we evolve as traders over time, and it can be very worthwhile to go back and revisit things we’ve read in the past for new insights. I’ve certainly done that with the [easyazon-link asin=”1592802974″]Market Wizards[/easyazon-link] books over the years, and it’s one reason I continue reading new books on a regular basis even though I’ve been in the markets for over 20 years now.

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Trading Tips

It’s only a paper loss if you don’t sell

Wow!

I just read an article titled Why Investing With Emotions Doesn’t Pay Off that I had flagged a couple days ago as maybe having something my readers would find interesting. Everything started off pretty well. It was the standard stuff about not making emotional decisions with your investments. No surprises there.

Then I hit a part where the author, who indicates she’s some kind of financial planner, talks about a client wanting to move money out of equity funds and into a money market. The client wanted to wait out the market uncertainty and wait for things to turn back around (I don’t know when this event took place).

Here’s the response she provided:

I explained to my client that he has not yet realized the investment loss, currently it is only on paper because he has not yet sold the investments.  I advised him against selling any of his investments because the current market value was a lot less than his actual cost (book value).

Has not realized a loss? Only a paper loss? I’m sorry, but if the value of your assets has decline, you have taken a loss.

So the advice here is not to realize a loss? Notice there’s nothing in there in terms of actual strategy. The author just doesn’t want her client taking a loss. This is the sort of attitude that kills traders and investors alike (“I’ll get out when it comes back”, etc.). I agree with the article’s basic premise that emotional decisions should be avoided (wrote a little about that yesterday), but there’s nothing wrong with taking a loss. In a lot of cases it’s the best thing you can do.

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Trading Tips

Some Steps Toward Emotional Control

While surfing the BabyPips forum recently I came upon a thread linked to a discussion of emotional control in trading. The original article (which I think came from a newsletter) had the title “7 Steps for Keeping Your Emotions in Check during Tough Markets”. The Steps were as follows:

#1: Do not over-trade.

#2: Do not take on too much risk.

#3: Do not look back.

#4: Do not sell your winners too soon.

#5: Do not hang on to losers too long.

#6: Keep your ego out of your trading.

#7: Find a good plan and stick with it.

In my view, the only three items on this list which actually help control emotions are #3, #6 and #7. Putting prior trades in the rear view mirror tends to help us not get caught up in past performance, as does trading with a minimum of ego. Sticking to a good plan, of course, is an absolute must for keeping an even keel when trading.

The rest of the Steps, to my mind, are actually things that are more the results of overly emotional trading rather than causes. We over-trade, take on too much risk, cut winners early and hang on to losers because we are emotional. As such, I’d say not doing those things helps to minimize the impact of emotions on trading, but they don’t really keep emotions in check, so to speak.

That’s just my view. What do you think?

Categories
Trading Book Reviews

Book Review: The Inner Voice of Trading

[easyazon-link asin=”0132616254″][/easyazon-link]I’ve read a whole lot of trading books over the years. At this point there isn’t much that really gets me excited when going through a new one. I have to say, though, that [easyazon-link asin=”0132616254″]The Inner Voice of Trading: Eliminate the Noise, and Profit from the Strategies That Are Right for You[/easyazon-link] by Michael Martin is very much an exception. From very early on it grabbed my attention and kept it.

I was not familiar with the author before reading the book, so aside from the obvious trading psychology focused implied by the title, I really didn’t know what to expect. What I found was a very engaging discussion of many aspects of the mental side of trading. Martin combines anecdotes from his own trading with wisdom from some of the [easyazon-link asin=”1592802974″]Market Wizards[/easyazon-link], among others, into a very worthwhile read.

Know yourself, trade to your personality
The two major themes of The Inner Voice of Trading are that you need a trading methodology which suits your personality and that successful traders are very conscious of their own emotional states. The former is something you hear quite often (and rightly so). The latter takes things a little beyond the usual “be disciplined” type of trading psychology dogma into the realm of emotional intelligence. Martin makes the point that developing traders spend too much time focusing on mechanics and external education, and not nearly enough time cultivating their internal tools.

Develop a meditation routine
The author is clearly a fan of meditation as a way to develop emotional intelligence. He talks about it throughout the text. His own personal meditative practice seems to be yoga oriented, but he also talks about other forms of mediation. For example, one of the traders he mentions runs as his meditative exercise. The point is to do something both to develop your emotional self-awareness and to put yourself in the right mindset for the trading day. In many ways you can think of it like the pre-game routine athletes use to prepare for competition. The idea and intent is the same, though obviously the methods vary considerably.

My one little gripe with the book is its lack of structure. There are chapters, but the subject matter tends to wind around, back and forth. It’s a relatively short book, and and easy read, though. Overall, I think [easyazon-link asin=”0132616254″]The Inner Voice of Trading[/easyazon-link] is very worth while and I would recommend it just about any trader.

Make sure to check out all my trading book reviews.

Categories
Trading Tips

Lessons for traders from neurofinance research

Neurofinance is one of the sub-fields in the area of Behavioral Finance research. It’s the area which focuses on how out brain works. During the conference I attended last week there was a set of presentations on the subject that were very interesting. I thought they would be well worth sharing here.

The impact of learning
One of the papers presented was titled “Brain, Financial Market Bubbles, and Investing” by Dr. Paul Zak from Claremont Graduate University. Basically, Dr. Zak described an experiment he was part of running in which the impact of learning was gauged in terms of the actions of “traders” in the formation of bubbles. The conclusions were interesting.

The bubble experiment is one where a group of people are given the opportunity to trade a fictional market for a depreciating asset. By definition, this is a market that must eventually go to zero, yet consistently through these sorts of experiments there are clear bubbles being formed in the markets (meaning prices go well above fundamental value). Research has found, however, that as participants repeat the experiment the bubbles tend to become less extreme, indicating a learning aspect.

The experiment about which the Zak paper was written was an effort to see just how significant that learning factor is in bubble formation. Using drugs, the researchers impaired the learning facility of about a third of participants. The result was that those traders did not learn as quickly as the others, and thus it took longer to see the same reduction in bubble formation than in the non-drugged group (actually, the non-drugged group was 50% on a placebo and 50% on caffeine pills, but there was no significant difference in performance).

Zak’s conclusions were three-fold. First, market participants must learn market history so they know what the market has done before. Second, learning must be “salient”, meaning it involves actually risk and reward (in other words real money trading, not demo trading, as I have suggested on many occasions). The last was that trading frequency relates inversely to the potential for a market to form a bubble (think real estate as a prime example).

Understanding your brain
[easyazon-link asin=”0470543582″][/easyazon-link]The other key presentation in this area was from Richard Peterson, co-author with Frank Murtha of [easyazon-link asin=”0470543582″]MarketPsych: How to Manage Fear and Build Your Investor Identity[/easyazon-link]. Peterson made two really interesting points that I think traders should latch on to as part of their development.

First, from a real neuro perspective, he noted that greed actually turns off the fear centers in the brain. This is scientific evidence of what many traders already know – that when we start thinking overly much above what we could make in the market it shorts out the part of our brain where we process the risk. As a result, we take too much risk and otherwise act stupidly.

The other point Richardson made was that we are naturally inclined to want to “do something” in times of stress. This is where a good trading plan comes in (see my series of trading plan posts). It gives us specific action items to do so that our natural instincts – which rarely work in our favor when trading – don’t override our ability to do what needs to be done, even if that is actually nothing at all.