Join our investing community

Trading The Secret to Trading Brilliantly

Discussion in 'Shares' started by Tropo, 6th Oct, 2010.

  1. Tropo

    Tropo Well-Known Member

    Joined:
    17th Aug, 2005
    Posts:
    3,396
    Location:
    NSW
    Tate on Trading - The Secret to Trading Brilliantly

    IN AN ACT OF SUPREME GENEROSITY, I am going to offer you the secret to trading.
    This is a secret which separates good traders from bad. It is a secret that poor traders do not want to hear about, but good traders are willing talk about all day.
    So grab a pencil and start scribbling.

    The secret is simple - do not do your dough.

    I bet you that was a shattering revelation to most.
    Now money management is a topic that is often written about and it is a topic that I harp on about all the time but I feel motivated to write about it again after coming across a particularly pinheaded notion that people are paying money for.
    I was sent some material by someone in the business who suggested that all you need to do is to risk all your capital on one position and then sell if that position halves.
    Their logic was that if you do not lose all your capital and make 100% on what was left then you would be rich.
    It does not take much in the way of sophisticated statistics to show that this is a dimwitted idea.
    Consider a situation where you start with $50,000, you apply this logic but you get five trades wrong in a row.
    Now after five trades your account is down to $1,562.50.
    Remember the logic; you only exit a position when you have lost half your money.
    If your loss has been this extreme then to recoup your losses you will need to make over 3,000% on your remaining capital to get back to your starting point.
    Clearly this is a tall order and one most people would not survive emotionally. Despite this, I am certain that there will be people willing to pay to learn such a technique and it demonstrates well why people find trading so hard.
    When traders are studied in real life, they demonstrate a fascinating propensity to overestimate their own abilities particularly in the area of prediction.

    This overconfidence seems not to stem from an underestimating of the difficulty of the task nor from underestimating the level of competition they face but rather from an overestimation of their own abilities.

    After how hard could it be to make 100% on every trade?
    The genesis of a trader generally follows a set pattern.
    An individual wakes up one morning and decides that he/she will be a trader.
    The intriguing thing about this decision is that it is based on a complete lack of training.

    My own anecdotal experience is that many traders who have not traded shares or who have been unsuccessful share traders believe that complex derivatives offer a panacea to all their trading problems.

    Often the sum total of the experience of these individuals is that they have watched the movie Wall Street. Those who have seen the sequel consider themselves over prepared.
    This is somewhat akin to watching a medico documentary on the Discovery Channel and then turning up at your local hospital believing you are qualified to be a brain surgeon.
    Those of you who are astute will recognise the fundamental problem with this approach - apart from it being stupid. It flies in the face of one of the central tenets of trading and that is to not to allow your losses to run away from you.
    Letting losses get out of control often seems to be the standard behaviour for the overwhelming majority of traders yet it runs contrary to all the rules of trading.
    Traders' expectations are very slow to change. As a result, they fail to see when a position is moving into a loss. This leads to positions being held well past when they should be closed.
    The problem of holding onto losses is also a result of how we view or "frame" certain situations.

    In their seminal 1979, paper Prospect Theory: An Analysis of Decision under Risk, Daniel Kahneman and Amos Tversky noted that if an individual frames a situation as being negative, for example a losing position, then they would become risk seeking.
    This causes traders to hang onto losers and to commit the cardinal sin of averaging down.

    Negative framing occurs when a situation has a perceived negative outcome. In one of Kahneman and Tversky's experiments participants were asked to choose between the following
    1. An 80% chance to win $4,000 and a 20% chance of not winning anything at all.
    2. A 100% chance of winning $3,000.
    What would your choice be?

    The first choice offers the greatest expected outcome as defined by 0.80 x $4,000 which equals $3,200 despite it offering a higher expected value 80% of participants choose to go with the sure thing.
    When the situation is altered slightly, the participants were offered an 80% of losing $4,000 and a 20% chance of losing nothing or a 100% chance of losing $3,000.
    Some 92% of subjects opted for the scenario of an 80% chance of losing $4,000 as opposed to the defined loss of $3,000.

    This desire to gamble with losses is known as Prospect Theory. This theory states that traders over-weight losses when they are described as definitive as opposed to situations where they are possible.
    This is done even though the economic outcome from both situations is identical.
    It has been found that when a loss is defined in terms of the dollar amount involved and the loss is certain then traders will try to avoid the psychological pain inflicted by taking the loss.
    This will lead to traders seeking to avoid the loss by gambling with it, in doing so they seek to defer the pain losses bring.
    The interesting thing is that if a trade goes bad very quickly, the desire to become risk seeking is heightened further.
    This is referred to as the sunken cost effect and results in traders undertaking strategies such as averaging down.

    In the reverse situation of where a position is profitable, traders tend to become risk averse and close down winning positions quickly.
    The closing down of trades that show a profit and the keeping of losses has been termed the disposition effect.
    I will leave the final word on this to Jesse Livermore, one of the greatest traders of the last century and whose exploits are chronicled in Reminiscences of a Stock Operator.

    "I did precisely the wrong thing.
    The cotton showed me a loss and I kept it.
    The wheat showed me a profit and I sold it out…
    Of all the speculative blunders there are few greater than trying to average a losing game.
    Always sell what shows you a loss and keep what shows you a profit.
    That is so obviously the wise thing to do and was so well known to me that even now I marvel at myself for doing the reverse."


    - Chris Tate