Sunday, 24 March 2013
It looks very likely that we will gap up in the Euro pairs this Monday as Cyprus settles its problems. We may even go above 124.35, the close on Friday 16 March before the big drop on Monday. If I had just held on to those positions I would be unharmed! If I had the capacity to hold those positions, in the longer term this week would look like a minor wobble. Having seen this kind of thing happen many times before makes some traders (like me) not want to take the loss in the first place. However, a little more analysis shows that such a desire is wrong. I’ll go into the deeper argument of why it is wrong.
First, the account results so far: Account down -88.8% this month to $12,003 from $151,144 last week. Loss of -$139,141 this week. Attached to this post is the updated worksheet.
Investor, Speculator or Gambler?
In trading, and in fact in all of life, we all face risk all the time. Risk exists on a continuum from very low risk to very high risk. Where one sits on this continuous graph of risk determines how you prepare for and handle the risk, and whether you are called an investor or a gambler. Every decision has risks associated with it – there is no 100% ‘safe’ decision. The only difference is in the degree of risk and the time-horizon over which the risk is spread. An investor is one who takes a very long term view of his investment, typically measured in years. A speculator is one who takes risks over a very short period – hours to a few days. A gambler is one who is unaware of risks, or (what amounts to the same thing) ignores risks. The flip side of the coin is that the potential rewards are directly proportional to the risk one takes. So to an investor in safe T-bonds, the best outcome is to get back his principal+2% return over 10 years (in reality he is more likely to get his principal less 2% due to inflation). On the other end of the spectrum a trader stands to make as much as 10% or more in a day or two – an unthinkable, unimaginable return from a bond investor’s perspective. Even Buffet’s long term average of about 22% return per year looks risible compared to the returns of a speculator like George Soros or Paul Tudor Jones (famous forex trader). So it’s all a matter of where on the risk/return continuum one chooses to be.
As a forex trader I am in the speculator category. We all take risk, only over different time horizons. Even Warren Buffet’s long-term investments carry risk, just as my EURJPY trade carries risk. Buffet mitigates the risk by keeping leverage at almost zero and using only a small % of his total capital for each investment (so a poor investment does not blow up his account); he also investigates each trade thoroughly to avoid potential risks that can be foreseen e.g. poor management, fraudulent accounting, industry sector characteristics, the laws of the land, etc. The approach is the same in trading, only on a shorter time-frame. As a trader I should similarly mitigate my risk: do not risk so much that a negative outcome will blow up my account; plan the trade carefully taking into account all the foreseeable factors that might affect the trade viz. study the charts for likely market direction, look out for event risk (political, economic events, etc). Some risks simply cannot be foreseen to a useful level of accuracy, eg the earthquake/tsunami of March 2011. In trading the risks are magnified compared to investing. But the returns are similarly much greater.
WWW Analysis: What Went Wrong
A good trade consists of a good entry, a proper assessment of risk defined by an appropriate stop loss level, a proper order size in accordance with the risk that one can afford to take and good rules for when to exit. I am at the stage where I can be quite confident in my analysis and chart reading skills. These have been honed over many years and I have tested them in all kinds of market conditions. My trades, when planned calmly are usually good trades. That is one box I can confidently tick. The next step is the execution of the trade. This involves emotions and human nature. Emotions, and entering trades in the heat of the moment without proper analysis, is where I have often stumbled.
Over the years of trading, I have found that the old traders’ rules, even if they sound like a cliché, are true wisdom that every trader needs to absorb. Times change, technology advances, but human behaviour remains constant. The old wisdom basically consists of lessons learned from repeated experience of human behaviour. Those lessons are valid even in today’s global, internet age. The only change is that events move faster than they did in the age of horse and buggy.
- Plan the trade, trade the plan.
- The first loss is the best loss.
- Cut your losses and let your profits run.
- The market is never wrong. Traders are wrong.
By the way, the answer to the question in the first paragraph of the post – why I should not hold on to losing positions if I know that the market will bounce back after some time – is this: That was not my plan. My plan is based on my account equity and how much I can risk on each trade. There is a reason for that plan – a greater loss cannot be supported by my funds.
I have come a long way since when I started trading, but the markets are totally unforgiving of any mistakes. That is a crucial difference between the career of a trader compared to a professional accountant, or lawyer or software engineer. Mistakes in other careers are minor setbacks at most, but in trading one mistake can bust one’s account and almost end that career. So each time I suffer a debacle I think back to what my mistake was.
Over the past 2 years, I have had a few disasters and the common theme in these disasters in order of importance are:
1. I don’t like to take losses, and I don’t cut my losses in time.
2. I frequently don’t execute the trade as planned.
The first weakness is a personality issue, and it takes a long time to re-train my personality. I have made some progress in this direction, but when I make this mistakes it usually costs me very dearly. I have to become absolutely ruthless about cutting losses. The way I am doing it is I keep a parallel trading journal of my trades executed live, in real-time, as per my system rules. Each time I deviate from the theoretical trades, I review the reasons why and whether the outcome was better than the rule-based trades. I have found that the rule-based trading invariably comes out ahead, even in the case of big event risks such as elections and major economic news. Perhaps something like the Japanese earthquake/tsunami might have wiped off the system account if the stop loss is not honored by the broker (I had not developed my system rules at that time), so putting in a hard stop far away from the market is probably a good idea. Each review of my rule-based trades increases my confidence in my trade plans and strengthens my future resolve to stick to my plan.
The second weakness is due to too much ‘screen time’. Constantly monitoring the trades encourages the mind to second-guess the original plan. Watching the price jump 20 pips against my trade triggers emotions and the urge to do something. This leads to poor decisions like exiting a position before it reaches the stop loss level, or getting out of a profitable trade too soon compared to what eventually could have been a very nice large profit. To avoid this pitfall I need to occupy myself with other activities, but in such a way that I remain close to a computer and can take action if my platform alerts me to key levels being hit.
One related point is that trading is a very lonely line of work. I am by nature an extrovert, I like to meet people and discuss ideas and happenings. This ‘loneliness’ aspect troubles me a lot. I have to figure out a way to deal with it. One serious idea I am considering is to take up golf. Melbourne is a great city for golf – there is at least one good course in every suburb; I have a choice of nearly a dozen golf courses within a ten minute drive of my home. Golf with some friends and a laptop + mobile broadband in the cart should cover both requirements!
If I can correct my weaknesses, there is really no reason why I can’t earn between 50 – 80% most months. I am starting on this path today and looking forward to the day when my account reaches $100k again.