Saturday, July 22, 2017
A "trading rut" is invariably endured by almost all traders at some point in their trading experience. A trading rut is a point in time where profits are elusive, or losses may even be mounting. These losing or unprofitable streaks can happen to anyone at any time. It may occur because the market has shifted in some way. At other times, it may be because the trader has altered a strategy or is no longer adhering to a trading plan. No matter the reason for the slump, there are five questions a trader can ask to help isolate the problem so changes can be initiated and hopefully a return to profitability will ensue.
TUTORIAL: Trading Systems: Introduction
The following questions should be answered as honestly and as fully possible. Each will probe current market conditions and will require the trader's own strategies to be scrutinized. Traders should also realize that losing trades occur to everyone, and even the best trading system can experience a string of losses. Trading rules and strategies should not be questioned every time a losing trade occurs; these questions should be used when the trader is in a sustained period of unprofitability. Being aware of these questions should also keep traders on course at all times, helping to avoid "ruts" in the first place. (For additional reading, check out: Day Trading Strategies For Beginners.)
1. Is the investment product I am trading moving in such a way that it is even possible to produce a profit based on my methods?
Markets continually shift from low to high volatility and back, and ranging to trending and back again. Therefore, what works in one set of conditions may not work in another. A plan may be executed perfectly, but if executed in the wrong market environment it will likely be a losing endeavor.
Therefore, traders must consider if their entry points, stop levels, profit targets and money management strategies are viable in the current market conditions. If not, then the trader should avoid trading until conditions are more suitable, or create alternative strategies for the conditions.
2. Am I trading against the trend or with it?
Many traders develop strategies to capitalize on trends. Trends occur on different time frames, and which trends are currently relevant should be noted by the trader. Trading with the trend can be subjective in that a short-term trend is going one way and a longer term trend going the other. Therefore, being aware of multiple trends and deciding which ones to trade is a crucial factor in trading success.
If a trend following strategy is being used but is not profitable, traders must consider if the market is even trending. If a trend is occurring, the entry point is possibly too late (close to a correction point) in the move, or stop levels are too close to the price. If the strategy appears as if it should be profitable (but isn't), are the rules of the strategy being adhered to? It may not be the strategy but rather the trader's lack of discipline which is the problem (which is quite often the case).
3. Do I have a set of rules for entries and exits and am I following these rules?
If a trading rut is occurring, it could be because the trader doesn't have a detailed plan for how to enter and exit positions. Are entry and exit rules written out in detail? The details should include how and when trades will be entered and exited.
Traders must also question if they have made any small changes in how the plan is traded. An example is entering in real-time as a signal occurs, as opposed to waiting for the close of a price bar, or vice versa. Such a change could shift the dynamics of a strategy.
Also, have the entry and exit rules been tested in some fashion? Or are the rules based on unfounded assumptions? Strategies can be tested through backtesting, paper trading or a demo account if the viability of a strategy is questionable.
4. Am I trading all my signals or only certain ones?
When systems are created, especially if it is backtested, there is an assumption that all the signals produced by the strategy will be traded. If certain traders were filtered out of the results, these same trades should be filtered out in actual trading. Therefore, the trader must ask "Am I following my plan or am I making too many, or too few, trades?"
If additional trades are taken, which is not part of the trading plan, the plan should not be blamed. The trader should cease these excess trades until these trades can be incorporated into a profitable system.
If all the signals are not traded, this could skew the profitability of a strategy drastically. Traders should check to see if the trades being skipped are profitable ones. If so, trade the signals.
5. Have I created money management rules and am I following them?
One of the most important aspects of trading is money management. Each trade should only expose the trader to a very small amount of risk, ideally less than 1% of the trader's capital. Therefore, if money management rules are in place, are the rules being followed?
It is possible that rules may be in place, but in actual trading do losses end up larger than originally planned for? Slippage, or fees, can result in a loss being larger than anticipated, and can wreck a profitable strategy if risk is not properly accounted for. If losses are continually slightly (or greatly) larger than anticipated, reduce position size, switch to a broker with lower fees or stop trading a market where there is so much slippage, risk controls cannot be properly implemented.
The Bottom Line
A losing streak can happen to anyone, and likely will, if trading for a long enough time. A rut can be caused by changes in the market or in how a trader implements their rules. By scrutinizing their system, the trader can hopefully isolate the issues causing the string of losses so it can be fixed. Monitoring markets and determining if the system will even work is one way to do this. A trader should also monitor if they are trading with the trend or against it; if they have entry, exit and money management rules in place; if all signals are being traded and most importantly if all the rules in place are being followed. By examining the market and scrutinizing the trading plan (and how it is implemented), it is likely the cause of the "rut" can be found and the appropriate action taken to remedy the situation. (To know more about trading, read: Introduction To Swing Trading.)
Backtesting is a key component of effective trading-system development. It is accomplished by reconstructing, with historical data, trades that would have occurred in the past using rules defined by a given strategy. The result offers statistics that can be used to gauge the effectiveness of the strategy. Using this data, traders can optimize and improve their strategies, find any technical or theoretical flaws, and gain confidence in their strategy before applying it to the real markets. The underlying theory is that any strategy that worked well in the past is likely to work well in the future, and conversely, any strategy that performed poorly in the past is likely to perform poorly in the future. This article takes a look at what applications are used to backtest, what kind of data is obtained, and how to put it to use!
Tutorial: Basics of Technical Analysis
The Data and The Tools
Backtesting can provide plenty of valuable statistical feedback about a given system. Some universal backtesting statistics include:
- Net Profit or Loss - Net percentage gain or loss.
- Time frame - Past dates in which testing occurred.
- Universe - Stocks that were included in the backtest.
- Volatility measures - Maximum percentage upside and downside.
- Averages - Percentage average gain and average loss, average bars held.
- Exposure - Percentage of capital invested (or exposed to the market).
- Ratios - Wins-to-losses ratio.
- Annualized return - Percentage return over a year.
- Risk-adjusted return - Percentage return as a function of risk.
Typically, backtesting software will have two screens that are important. The first allows the trader to customize the settings for backtesting. These customizations include everything from time period to commission costs. Here is an example of such a screen in AmiBroker:
The second screen is the actual backtesting results report. This is where you can find all of the statistics mentioned above. Again, here is an example of this screen in AmiBroker:
In general, most trading software contains similar elements. Some high-end software programs also include additional functionality to perform automatic position sizing, optimization and other more-advanced features.
The 10 Commandments
There are many factors traders pay attention to when they are backtesting trading strategies. Here is a list of the 10 most important things to remember while backtesting:
- Take into account the broad market trends in the time frame in which a given strategy was tested. For example, if a strategy was only backtested from 1999-2000, it may not fare well in a bear market. It is often a good idea to backtest over a long time frame that encompasses several different types of market conditions.
- Take into account the universe in which backtesting occurred. For example, if a broad market system is tested with a universe consisting of tech stocks, it may fail to do well in different sectors. As a general rule, if a strategy is targeted towards a specific genre of stock, limit the universe to that genre; but, in all other cases, maintain a large universe for testing purposes.
- Volatility measures are extremely important to consider in developing a trading system. This is especially true for leveraged accounts, which are subjected to margin calls if their equity drops below a certain point. Traders should seek to keep volatility low in order to reduce risk and enable easier transition in and out of a given stock.
- The average number of bars held is also very important to watch when developing a trading system. Although most backtesting software includes commission costs in the final calculations, that does not mean you should ignore this statistic. If possible, raising your average number of bars held can reduce commission costs, and improve your overall return.
- Exposure is a double-edged sword. Increased exposure can lead to higher profits or higher losses, while decreased exposure means lower profits or lower losses. However, in general, it is a good idea to keep exposure below 70% in order to reduce risk and enable easier transition in and out of a given stock.
- The average-gain/loss statistic, combined with the wins-to-losses ratio, can be useful for determining optimal position sizing and money management using techniques like the Kelly Criterion. (See Money Management Using the Kelly Criterion.) Traders can take larger positions and reduce commission costs by increasing their average gains and increasing their wins-to-losses ratio.
- Annualized return is important because it is used as a tool to benchmark a system\'s returns against other investment venues. It is important not only to look at the overall annualized return, but also to take into account the increased or decreased risk. This can be done by looking at the risk-adjusted return, which accounts for various risk factors. Before a trading system is adopted, it must outperform all other investment venues at equal or less risk.
- Backtesting customization is extremely important. Many backtesting applications have input for commission amounts, round (or fractional) lot sizes, tick sizes, margin requirements, interest rates, slippage assumptions, position-sizing rules, same-bar exit rules, (trailing) stop settings and much more. To get the most accurate backtesting results, it is important to tune these settings to mimic the broker that will be used when the system goes live.
- Backtesting can sometimes lead to something known as over-optimization. This is a condition where performance results are tuned so highly to the past that they are no longer as accurate in the future. It is generally a good idea to implement rules that apply to all stocks, or a select set of targeted stocks, and are not optimized to the extent that the rules are no longer understandable by the creator.
- Backtesting is not always the most accurate way to gauge the effectiveness of a given trading system. Sometimes strategies that performed well in the past fail to do well in the present. Past performance is not indicative of future results. Be sure to paper trade a system that has been successfully backtested before going live to be sure that the strategy still applies in practice.
Backtesting is one of the most important aspects of developing a trading system. If created and interpreted properly, it can help traders optimize and improve their strategies, find any technical or theoretical flaws, as well as gain confidence in their strategy before applying it to the real world markets.
Traders who are eager to try a trading idea in a live market often make the mistake of relying entirely on backtesting results to determine whether the system will be profitable. While backtesting can provide traders with valuable information, it is often misleading and it is only one part of the evaluation process. Out-of-sample testing and forward performance testing provide further confirmation regarding a system's effectiveness, and can show a system's true colors, before real cash is on the line. Good correlation between backtesting, out-of-sample and forward performance testing results is vital for determining the viability of a trading system. (We offer some tips on this process that can help refine your current trading strategies. To learn more, read Backtesting: Interpreting the Past.)
Backtesting refers to applying a trading system to historical data to verify how a system would have performed during the specified time period. Many of today's trading platforms support backtesting. Traders can test ideas with a few keystrokes and gain insight into the effectiveness of an idea without risking funds in a trading account. Backtesting can evaluate simple ideas, such as how a moving average crossover would perform on historical data, or more complex systems with a variety inputs and triggers.
As long as an idea can be quantified it can be backtested. Some traders and investors may seek the expertise of a qualified programmer to develop the idea into a testable form. Typically this involves a programmer coding the idea into the proprietary language hosted by the trading platform. The programmer can incorporate user-defined input variables that allow the trader to "tweak" the system. An example of this would be in the simple moving average crossover system noted above: the trader would be able to input (or change) the lengths of the two moving averages used in the system. The trader could backtest to determine which lengths of moving averages would have performed the best on the historical data. (Get more insight in the Electronic Trading Tutorial.)
Many trading platforms also allow for optimization studies. This entails entering a range for the specified input and letting the computer "do the math" to figure out what input would have performed the best. A multi-variable optimization can do the math for two or more variables combined to determine what levels together would have achieved the best outcome. For example, traders can tell the program which inputs they would like to add into their strategy; these would then be optimized to their ideal weights given the tested historical data.
Backtesting can be exciting in that an unprofitable system can often be magically transformed into a money-making machine with a few optimizations. Unfortunately, tweaking a system to achieve the greatest level of past profitability often leads to a system that will perform poorly in real trading. This over-optimization creates systems that look good on paper only.
Curve fitting is the use of optimization analytics to create the highest number of winning trades at the greatest profit on the historical data used in the testing period. Although it looks impressive in backtesting results, curve fitting leads to unreliable systems since the results are essentially custom-designed for only that particular data and time period.
Backtesting and optimizing provide many benefits to a trader but this is only part of the process when evaluating a potential trading system. A trader's next step is to apply the system to historical data that has not been used in the initial backtesting phase. (The moving average is easy to calculate and, once plotted on a chart, is a powerful visual trend-spotting tool. For more information, read Simple Moving Averages Make Trends Stand Out.)
In-Sample vs. Out-of-Sample Data
When testing an idea on historical data, it is beneficial to reserve a time period of historical data for testing purposes. The initial historical data on which the idea is tested and optimized is referred to as the in-sample data. The data set that has been reserved is known as out-of-sample data. This setup is an important part of the evaluation process because it provides a way to test the idea on data that has not been a component in the optimization model. As a result, the idea will not have been influenced in any way by the out-of-sample data and traders will be able to determine how well the system might perform on new data; i.e. in real-life trading.
Prior to initiating any backtesting or optimizing, traders can set aside a percentage of the historical data to be reserved for out-of-sample testing. One method is to divide the historical data into thirds and segregate one-third for use in the out-of-sample testing. Only the in-sample data should be used for the initial testing and any optimization. Figure 1 shows a time line where one-third of the historical data is reserved for out-of-sample testing, and two-thirds are used for the in-sample testing. Although Figure 1 depicts the out-of-sample data in the beginning of the test, typical procedures would have the out-of-sample portion immediately preceding the forward performance.
Figure 1: A time line representing the relative length of in-sample and out-of-sample data used in the backtesting process.
Once a trading system has been developed using in-sample data, it is ready to be applied to the out-of-sample data. Traders can evaluate and compare the performance results between the in-sample and out-of-sample data.
Correlation refers to similarities between the performances and the overall trends of the two data sets. Correlation metrics can be used in evaluating strategy performance reports created during the testing period (a feature that most trading platforms provide). The stronger the correlation between the two, the better the probability that a system will perform well in forward performance testing and live trading. Figure 2 illustrates two different systems that were tested and optimized on in-sample data, then applied to out-of-sample data. The chart on the left shows a system that was clearly curve-fit to work well on the in-sample data and completely failed on the out-of-sample data. The chart on the right shows a system that performed well on both in- and out-of-sample data.
Figure 2: Two equity curves. The trade data before each yellow arrow represents in-sample testing. The trades generated between the yellow and red arrows indicate out-of-sample testing. The trades after the red arrows are from the forward performance testing phases.
If there is little correlation between the in-sample and out-of-sample testing, like the left chart in Figure 2, it is likely that the system has been overoptimized and will not perform well in live trading. If there is strong correlation in the performance, as seen in the right chart in Figure 2, the next phase of evaluation involves an additional type of out-of-sample testing known as forward performance testing. (For more reading about forecasting, refer to Financial Forecasting: The Bayesian Method.)
Forward Performance Testing Basics
Forward performance testing, also known as paper trading, provides traders with another set of out-of-sample data on which to evaluate a system. Forward performance testing is a simulation of actual trading and involves following the system's logic in a live market. It is also called paper trading since all trades are executed on paper only; that is, trade entries and exits are documented along with any profit or loss for the system, but no real trades are executed. An important aspect of forward performance testing is to follow the system's logic exactly; otherwise, it becomes difficult, if not impossible, to accurately evaluate this step of the process. Traders should be honest about any trade entries and exits and avoid behavior like cherry picking trades or not including a trade on paper rationalizing that "I would have never taken that trade." If the trade would have occurred following the system's logic, it should be documented and evaluated.
Many brokers offer a simulated trading account where trades can be placed and the corresponding profit and loss calculated. Using a simulated trading account can create a semi-realistic atmosphere on which to practice trading and further assess the system.
Figure 2 also shows the results for forward performance testing on two systems. Again, the system represented in the left chart fails to do well beyond the initial testing on in-sample data. The system shown in the right chart, however, continues to perform well through all phases, including the forward performance testing. A system that shows positive results with good correlation between in-sample, out-of-sample and forward performance testing is ready to be implemented in a live market.
The Bottom Line
Backtesting is a valuable tool available in most trading platforms. Dividing historical data into multiple sets to provide for in-sample and out-of-sample testing can provide traders a practical and efficient means for evaluating a trading idea and system. Since most traders employ optimization techniques in backtesting, it is important to then evaluate the system on clean data to determine its viability. Continuing the out-of-sample testing with forward performance testing provides another layer of safety before putting a system in the market risking real cash. Positive results and good correlation between in-sample and out-of-sample backtesting and forward performance testing increases the probability that a system will perform well in actual trading. (For a comprehensive overview on technical analysis, see Technical Analysis: Introduction.)
Beginner Trading Fundamentals By Jean Folger
Trading is an active style of participating in the financial markets, which seeks to outperform traditional buy-and-hold investing. Instead of waiting to profit from long-term uptrends in the markets, traders seek short-term price moves in order to profit during both rising and falling markets. As a trader, you can be your own boss, work from home, set your own schedule and have the opportunity to achieve unlimited income potential. These factors, combined with the ease with which someone can enter the field, help make trading attractive.
While it's relatively easy to start trading - after all, you don't need any advanced degrees or specialized training - it is very difficult to become good at it and to become successful. It's not uncommon for someone who wants to trade for a living to overlook the financial, emotional and time commitments that are required to build a successful trading business. As a result, about 90% of day traders fail within the first year. Having a strategic approach, both in terms of your overall business and your actual trading activity, is an essential part of becoming a profitable trader.
In the first part of our beginner trading series, How To Start Trading, we emphasized the need to approach trading as a business and not as a hobby. In addition, we explored:
Trading styles - position, swing, day and scalp trading
Trading technology - computers, trading software, market analysis, testing and order execution
Order types - market, limit, stop, stop loss, conditional and duration
Trading plan development - market, chart interval, indicators, position sizing, entry rules, trade filters and exit rules
Testing your trading plan - backtesting, in-sample and out-of-sample testing, and forward performance testing
Live trading performance - trader errors, fills, technical problems and unique trading conditions
Here, in the second part of our beginner trading series, we introduce additional concepts that are important to traders, including:
Leverage and margin
Popular trading instruments
Record keeping and taxes
Most people who are interested in learning how to become profitable traders need only spend a few minutes online before reading such phrases as "plan your trade; trade your plan" and "keep your losses to a minimum." For new traders, these tidbits of information can seem more like a distraction than any actionable advice. New traders often just want to know how to set up their charts so they can hurry up and make money.
To be successful in trading, however, one needs to understand the importance of and adhere to a set of rules that have guided all types of traders, with a variety of trading account sizes. Each rule alone is important, but when they work together the effects are strong. Trading with these rules can greatly increase the odds of succeeding in the markets.
Rule No.1: Always Use a Trading Plan
A trading plan is a written set of rules that specifies a trader's entry, exit and money management criteria. Using a trading plan allows traders to do this, although it is a time consuming endeavor.
With today's technology, it is easy to test a trading idea before risking real money. Backtesting, applying trading ideas to historical data, allows traders to determine if a trading plan is viable, and also shows the expectancy of the plan's logic. Once a plan has been developed and backtesting shows good results, the plan can be used in real trading. The key here is to stick to the plan. Taking trades outside of the trading plan, even if they turn out to be winners, is considered poor trading and destroys any expectancy the plan may have had. (Learn more about backtesting in Backtesting: Interpreting the Past.)
Rule No.2: Treat Trading Like a Business
In order to be successful, one must approach trading as a full- or part-time business - not as a hobby or a job. As a hobby, where no real commitment to learning is made, trading can be very expensive. As a job it can be frustrating since there is no regular paycheck. Trading is a business, and incurs expenses, losses, taxes, uncertainty, stress and risk. As a trader, you are essentially a small business owner, and must do your research and strategize to maximize your business's potential.
Rule No.3: Use Technology to Your Advantage
Trading is a competitive business, and one can assume the person sitting on the other side of a trade is taking full advantage of technology. Charting platforms allow traders an infinite variety of methods for viewing and analyzing the markets. Backtesting an idea on historical data prior to risking any cash can save a trading account, not to mention stress and frustration. Getting market updates with smartphones allows us to monitor trades virtually anywhere. Even technology that today we take for granted, like high-speed internet connections, can greatly increase trading performance.
Using technology to your advantage, and keeping current with available technological advances, can be fun and rewarding in trading.
Rule No.4: Protect Your Trading Capital
Saving money to fund a trading account can take a long time and much effort. It can be even more difficult (or impossible) the next time around. It is important to note that protecting your trading capital is not synonymous with not having any losing trades. All traders have losing trades; that is part of business. Protecting capital entails not taking any unnecessary risks and doing everything you can to preserve your trading business. (See Risk Management Techniques For Active Traders for more.)
Rule No.5: Become a Student of the Markets
Think of it as continuing education - traders need to remain focused on learning more each day. Since many concepts carry prerequisite knowledge, it is important to remember that understanding the markets, and all of their intricacies, is an ongoing, lifelong process.
Hard research allows traders to learn the facts, like what the different economic reports mean. Focus and observation allow traders to gain instinct and learn the nuances; this is what helps traders understand how those economic reports affect the market they are trading. (Read about 24 different economic reports in our Economic Indicators Tutorial.)
World politics, events, economies - even the weather - all have an impact on the markets. The market environment is dynamic. The more traders understand the past and current markets, the better prepared they will be to face the future.
Rule No.6: Risk Only What You Can Afford to Lose
In rule No.4, I mentioned that funding a trading account can be a long process. Before a trader begins using real cash, it is imperative that all of the money in the account be truly expendable. If it is not, the trader should keep saving until it is.
It should go without saying that the money in a trading account should not be allocated for the kid's college tuition or paying the mortgage. Traders must never allow themselves to think they are simply "borrowing" money from these other important obligations. One must be prepared to lose all the money allocated to a trading account.
Losing money is traumatic enough; it is even more so if it is capital that should have never been risked to begin with.
Rule No.7: Develop a Trading Methodology Based on Facts
Taking the time to develop a sound trading methodology is worth the effort. It may be tempting to believe in the "so easy it's like printing money" trading scams that are prevalent on the internet. But facts, not emotions or hope, should be the inspiration behind developing a trading plan.
Traders who are not in a hurry to learn typically have an easier time sifting through all of the information available on the internet. Consider this: if you were to start a new career, more than likely you would need to study at a college or university for at least a year or two before you were qualified to even apply for a position in the new field. Expect that learning how to trade demands at least the same amount of time and factually driven research and study. (Refer to Day Trading Strategies For Beginners for a primer on picking the right strategy.)
Rule No.8: Always Use a Stop Loss
A stop loss is a predetermined amount of risk that a trader is willing to accept with each trade. The stop loss can be either a dollar amount or percentage, but either way it limits the trader's exposure during a trade. Using a stop loss can take some of the emotion out of trading, since we know that we will only lose X amount on any given trade.
Ignoring a stop loss, even if it leads to a winning trade, is bad practice. Exiting with a stop loss, and thereby having a losing trade, is still good trading if it falls within the trading plan's rules. While the preference is to exit all trades with a profit, it is not realistic. Using a protective stop loss helps ensure that our losses and our risk are limited.
Rule No.9: Know When to Stop Trading
There are two reasons to stop trading: an ineffective trading plan, and an ineffective trader.
An ineffective trading plan shows much greater losses than anticipated in historical testing. Markets may have changed, volatility within a certain trading instrument may have lessened, or the trading plan simply is not performing as well as expected. One will benefit by remaining unemotional and businesslike. It might be time to reevaluate the trading plan and make a few changes, or to start over with a new trading plan. An unsuccessful trading plan is a problem that needs to be solved. It is not necessarily the end of the trading business.
An ineffective trader is one who is unable to follow his or her trading plan. External stressors, poor habits and lack of physical activity can all contribute to this problem. A trader who is not in peak condition for trading should consider a break to deal with any personal problems, be it health or stress or anything else that prohibits the trader from being effective. After any difficulties and challenges have been dealt with, the trader can resume.
Rule No.10: Keep Trading in Perspective
It is important to stay focused on the big picture when trading. A losing trade should not surprise us - it is a part of trading. Likewise, a winning trade is just one step along the path to profitable trading. It is the cumulative profits that make a difference. Once a trader accepts wins and losses as part of the business, emotions will have less of an effect on trading performance. That is not to say that we cannot be excited about a particularly fruitful trade, but we must keep in mind that a losing trade is not far off.
Setting realistic goals is an essential part of keeping trading in perspective. If a trader has a small trading account, he or she should not expect to pull in huge returns. A 10% return on a $10,000 account is quite different than a 10% return on a $1,000,000 trading account. Work with what you have, and remain sensible.
Understanding the importance of each or these trading rules, and how they work together, can help traders establish a viable trading business. Trading is hard work, and traders who have the discipline and patience to follow these rules can increase their odds of success in a very competitive arena.
The popularization of speculative trading in the financial markets, partly due to the development of retail trading solutions offered on the internet, has created a new population of traders in the market. Most of these traders are non-professionals that are attracted by the potential to generate revenue quickly.
Falsely Created Expectations
Many novice traders may believe that it is very easy to make money, especially when they are trying a broker service using a free practice account.
However, if these traders manage to generate a sudden substantial return, it can lead them to believe that trading is an easy occupation - one in which revenue can be quickly generated with little work by the trader. For the inexperienced, one good pick can make it seem like market speculation is the key to success and wealth.
Unfortunately, when these inexperienced speculators overtake this virtual investing environment and decide to start trading live accounts and risking real money on the market, the activity becomes much more complex. In many cases, the days of outstanding day-trading performance come to look suddenly and distressingly like old souvenirs - it is an abrupt initiation into the pitiless reality of the financial markets.
Real Life vs. Practice
When new traders take the leap from their virtual trading accounts to trading with real money, they enter into the most difficult step of their initiation to trading: trading psychology.
In other words, while it may be easy to trade when the risk of loss does not exist, when the trader's hard-earned dollars are thrown into the mix, his or her focus and price objective can go out the window. Often, traders using virtual accounts will feel relatively comfortable even when the market moves against the positions they enter. This allows them to keep their focus on their price objective and wait for the market to get moving in the right direction. Because there is little consequence tied to "virtual money", personal emotion does not interfere. Unfortunately, when a trader's actions come to affect the gain or loss of his or her own personal assets, that trader is less likely to behave in such a methodical way.
Emotions Can Rule the Trade
Emotions can be seen as the trader's worst enemies; they often lead to misjudgment and loss.
Feelings generate what psychologist Roland Barach calls "mindtraps" in his book, "Mindtraps: Unlocking the Key to Investment Success" (1988). Roland Barach provides a collection of 88 lessons explaining the pitfalls, such as fear and greed, that hold many traders back.
Greed can lead a trader to hold on to a position too long in hopes of a higher price, even as it falls. This emotion has been the main reason behind many trades that have gone from large gains to large losses. To thwart this emotion, try to take an objective look at the reasoning behind your positions. When one of your positions experiences a large run-up, ask yourself whether the reasons behind your initial investment still remain; if not, it may be time to close or reduce the position.
Fear can prevent a trader from entering trades and lead to taking them out of positions far too early. If an investor is too concerned with potential loss and the risks that come with an investment, he or she can often be dissuaded from a good opportunity. Also, if a trader is more susceptible to fear, he or she may sell out of an investment far too early based on the fear of losing the gain he/she has made. In many cases, this can prevent a trader from cashing in on a much bigger gain.
Paralyze by Analyze
Paralyze by analyze is an interesting phenomenon in which traders get so caught up in analyzing everything about a potential investment, they never actually pull the trigger on the trade. In this case, what often happens is that the investor will constantly question all of the little details found in the analysis in an attempt to perfectly analyze a situation. This is a truly unachievable task, which can prevent a trader both from making monetary gains and from making experiential gains by getting into the trade.
A wide range of other emotions can rule a trader, but the important thing for any market participant is to recognize these emotions.
Acknowledge Your Emotions
All traders will experience at least one mindtrap, but the very best traders learn to recognize, understand and neutralize them. This process forms the foundation of any trader's training. Therefore, if you want to become a successful trader, you should first spend some time getting to know yourself and the particular mindtraps you tend to fall into. A skillful trader tends to have a strong desire to master his or her emotions and prevent them from affecting his or her performance.
Traders are only human and, as such, perfection may not exist in trading. However, profitable trading can be achieved when a trader learns to manage his or her emotions. This will be easier for some than for others, but it is only through experience in the market that this skill can be developed. Therefore, before you can learn how to win, you have to take some risks (or at least get into the market) and learn to master the emotions that making (and sometimes losing) money stirs up.
How does one integrate losses into a successful trading strategy? A logical and disciplined handling of "loss psychology" is important in order to turn negative experiences into positive ones. In this article, we'll identify the common traps that arise when emotional commitment and psychological reactions get in the way of investing.
Learning From Losses
It is no secret that losses are part of trading, but this does not make them easy to take or deal with. Emotional commitment and a lack of discipline should not be a part of trading; despite this, they play a key decision-making role for many investors and many traders suffer from negative psychological effects that impact their behavior.
For this reason, every investor must know how to handle negative experiences. The golden rule is to differentiate between those based on rational and prudent trading strategies on the one hand and emotionally-based, panicky decisions on the other. The former generally leads to success over time, while the latter tends to lead to failure.
Can traders really break free from their fear of financial losses? Absolutely, but doing this successfully requires looking at what has happened logically and from a conscious psychological perspective so you can act accordingly. Losses can have a value, but only if you take the time to learn and understand that some losses are simply inevitable, and undertake "loss management" to deal with them, rather than letting them get out of control. (For further reading, see Trading Psychology And Discipline.)
Loss Through Paralysis
The most commonly observed symptom of bad loss management is deterioration in discipline and an inability to exploit the prevailing trading opportunities at the time. This can mean being frozen into total inactivity. Losses that are disastrous are likely to stun the investor so that he sits on them, trying to rationalize leaving things as they are. This can happen when a trader becomes complacent and believes that he or she knows the investment will have a positive outcome.
In this state, if the market situation changes radically for the worse and leads to significant losses, the trader will be shocked. This can trigger a spiral of irrational decisions. For instance, stop-loss criteria may become too tight as the trader recoils in horror from further potential losses. Fear and a loss of self confidence may also further prevent the trader from acting sensibly, or, as explained earlier, acting at all.
Oftentimes, a dealer with a fair amount of money or who has done reasonably well for some time may start to overestimate either his own abilities or what can realistically be achieved in the markets. After a lengthy and profitable period, something suddenly goes wrong.
In the worst-case scenario, the trader plunges frantically into anything that looks profitable, no matter what the risks, and then desperately leaps out again at any hint of a downturn. For many an intrepid investor, this spiral ends only when the money runs out.
As a result, what often starts as a placid venture into equities and bonds, develops into a tempestuous ride through options, futures and equities in the most obscure places and markets, where booms and busts are the order of the day. The trader therefore becomes more risk friendly; there can even be a complete change in trading style and strategy. This change is not driven by rational decision-making, but by desperation and despair. Such traders may be seen driving a Rolls Royce one month and catching a bus the next. (For related reading, see Choose Your Own Asset Allocation Adventure.)
Losses As Part of Strategy
All good traders have the ability to formulate and apply a strategy without getting caught up in their own emotions. This includes the ability to handle losses in a positive and sensible manner. The right approach entails accepting the inevitability of losses, limiting them and understanding your own mentality and psychology. In many instances, losses need to be seen for what they are - an indicator that a strategic change is required. They may also be the result of natural market developments that could not have been predicted earlier. Therefore, a portfolio that becomes imbalanced needs to be restructured coolly and dispassionately. (For more insight, read Are You A Disciplined Investor?)
The situation must be handled with logic and discipline. "Emotional neutrality" may be the core concept. The presence of losses requires analysis to determine the cause. If the asset allocation is right in the first place, it may be sufficient to simply ride out the storm. If the balance is wrong, this needs to be adjusted to maintain an appropriate level of risk.
The main errors in trading are:
Attempting to win back losses by taking on more risk than you can afford or are comfortable with
Taking on so little risk that you cannot possibly make any money in the long run
In short, if you were doing something wrong, get it right. Alternatively, if the markets were simply adverse, react to them as you would advise a third party to do. Do not let your emotions take control. Do only to yourself what you would advise others to do. (To learn more about risk tolerance, read Personalizing Risk Tolerance.)
Avoiding Real Blunders Is Also Fundamental
Of course, some losses should not occur. Risk profiles must be adhered to from start to finish, and the money must be well managed in general. The up-front, proactive part of handling losses entails avoiding bad investment decisions in the first place.
Provided your investments make sense in the first place and are well managed, losses are simply inevitable to some degree and in some situations. It is necessary to take them in stride and react prudently, dispassionately and strategically. Either let the relevant markets right themselves over time, as they often do, or rebalance and restructure according to the well-proven principles of asset allocation and fund management.
For insight on how to overcome mental hurdles when trading, read Master Your Trading Mindtraps.
There are many characteristics and skills required by traders in order for them to be successful in the financial markets. The ability to understand the inner workings of a company, its fundamentals and the ability to determine the direction of the trend are a few of the key traits needed, but not one of these is as important as the ability to contain emotions and maintain discipline.
Tutorial: Managing Risk And Diversification
The psychological aspect of trading is extremely important, and the reason for that is fairly simple: A trader is often darting in and out of stocks on short notice, and is forced to make quick decisions. To accomplish this, they need a certain presence of mind. They also, by extension, need discipline, so that they stick with previously established trading plans and know when to book profits and losses. Emotions simply can't get in the way. (To read more about trading psychology, see Master Your Trading Mindtraps or discuss at Trading Psychology forum.)
When a trader's screen is pulsating red (a sign that stocks are down) and bad news comes about a certain stock or the general market, it's not uncommon for the trader to get scared. When this happens, they may overreact and feel compelled to liquidate their holdings and go to cash or to refrain from taking any risks. Now, if they do that they may avoid certain losses - but they also will miss out on the gains.
Traders need to understand what fear is - simply a natural reaction to what they perceive as a threat (in this case perhaps to their profit or money-making potential). Quantifying the fear might help. Or that they may be able to better deal with fear by pondering what they are afraid of, and why they are afraid of it.
Also, by pondering this issue ahead of time and knowing how they may instinctively react to or perceive certain things, a trader can hope to isolate and identify those feelings during a trading session, and then try to focus on moving past the emotion. Of course this may not be easy, and may take practice, but it's necessary to the health of an investor's portfolio. (For more, see Understanding Investor Behavior.)
Greed Is Your Worst Enemy
There's an old saying on Wall Street that "pigs get slaughtered." This greed in investors causes them to hang on to winning positions too long, trying to get every last tick. This trait can be devastating to returns because the trader is always running the risk of getting whipsawed or blown out of a position.
Greed is not easy to overcome. That's because within many of us there seems to be an instinct to always try to do better, to try to get just a little more. A trader should recognize this instinct if it is present, and develop trade plans based upon rational business decisions, not on what amounts to an emotional whim or potentially harmful instinct. (Keep reading about this in When Fear And Greed Take Over.)
The Importance of Trading Rules
To get their heads in the right place before they feel the emotional or psychological crunch, investors can look at creating trading rules ahead of time. Traders can establish limits where they lay out guidelines based on their risk-reward relationship for when they will exit a trade - regardless of emotions. For example, if a stock is trading at $10/share, the trader might choose to get out at $10.25, or at $9.75 to put a stop loss or stop limit in and bail.
Of course, establishing price targets might not be the only rule. For example, the trader might say if certain news, such as specific positive or negative earnings or macroeconomic news, comes out, then he or she will buy (or sell) a security. Also, if it becomes apparent that a large buyer or seller enters the market, the trader might want to get out.
Traders might also consider setting limits on the amount they win or lose in a day. In other words, if they reap an $X profit, they're done for the day, or if they lose $Y they fold up their tent and go home. This works for investors because sometimes it is better to just "go on take the money and run," like the old Steve Miller song suggests even when those two birds in the tree look better than the one in your hand. (For more, see Removing The Barriers To Successful Investing.)
Creating a Trading Plan
Traders should try to learn about their area of interest as much as possible. For example, if the trader deals heavily and is interested in telecommunications stocks, it makes sense for him or her to become knowledgeable about that business. Similarly, if he or she trades heavily in energy stocks, it's fairly logical to want to become well versed in that arena.
To do this, start by formulating a plan to educate yourself. If possible, go to trading seminars and attend sell-side conferences. Also, it makes sense to plan out and devote as much time as possible to the research process. That means studying charts, speaking with management (if applicable), reading trade journals or doing other background work (such as macroeconomic analysis or industry analysis) so that when the trading session starts the trader is up to speed. A wealth of knowledge could help the trader overcome fear issues in itself, so it's a handy tool.
In addition, it's important that the trader consider experimenting with new things from time to time. For example, consider using options to mitigate risk, or set stop losses at a different place. One of the best ways a trader can learn is by experimenting - within reason. This experience may also help reduce emotional influences.
Finally, traders should periodically review and assess their performance. This means not only should they review their returns and their individual positions, but also how they prepared for a trading session, how up-to-date they are on the markets and how they're progressing in terms of ongoing education, among other things. This periodic assessment can help the trader correct mistakes, which may help enhance their overall returns. It may also help them to maintain the right mindset and help them to be psychologically prepared to do business. (For more, see Ten Steps To Building A Winning Trading Plan.)
It's often important for a trader to be able to read a chart and have the right technology so that their trades get executed, but there is often a psychological component to trading that shouldn't be overlooked. Setting trading rules, building a trading plan, doing research and getting experience are all simple steps that can help a trader overcome these little mind matters.
Access to leverage accounts, easy access to global brokers and the proliferation of trading systems promising riches are all promoting forex trading for the masses. However, it is important to keep in mind that the amount of capital traders have at their disposal will greatly affect their ability to make a living from trading. In fact, capital's role in trading is so important that even a slight edge can provide great returns. This is because an edge can be exploited for large monetary gains only through large enough positions and replication (or frequency). A trader's ability to implement size and replication when conditions are right is what separates a true professional from less-skilled traders. This is accomplished by - among many other things - not being undercapitalized.
So just how much capital is required? Find out how much income you need to meet your trading goals - and whether ultimately, your goals are realistic. (For more, check out Day Trading Strategies For Beginners.)
What Is Respectable Performance?
Every trader dreams of taking a small amount of capital and becoming a millionaire off of it. The reality is that it is unlikely to occur by trading a small account. While profits can accumulate and compound over time, traders with small accounts often feel pressured to use large amounts of leverage or take on excessive risk in order to build up their accounts quickly. Not realizing that professional fund managers often make less than 10-15% per year, traders with small accounts often assume they can make double, triple or even 10 times their money in a single year.
The reality is, when fees, commissions and/or spreads are factored in, a trader must exhibit skill just to break even. Take for example an S&P E-mini contract. Let's assume fees of $5 per round trip trading one contract and that a trader makes 10 round trip trades per day. In a month with 21 trading days this trader will have spent $1,050 on commissions alone, not to mention other fees such as internet, entitlements, charting or any other fees a trader may incur in the course of trading. If the trader started with a $50,000 account, in this example, he would have lost 2% of that balance in commissions alone.
If we assume that at least half the trades crossed the bid or offer and/or factoring slippage, 105 of the trades will put the trader offside $12.50 immediately. That is an additional $1,312.50 cost for entering trades. Thus, our trader is now in the hole $2,362.50 (close to 5% of his initial balance). This amount will have to be recouped through the profits on the investment before the investor can even start making money!
A Realistic Look at Fees
When fees are looked at in this way, just being profitable is admirable. But if an edge can found, those fees can be covered and a profit realized. Assuming that a trader can establish a one-tick edge, meaning on average they make only a one-tick profit per round trip, that trader will make:
210 trades x $12.50 = $2,625
Minus the $5 commissions the trader comes out ahead by:
$2625 - 1050 = $1,575, or a 3% return on the account per month
The average profit shows that while the trader has winning and losing trades, when the trades are averaged out the resulting profit is one tick or higher.
Making an average of one tick per trade erases fees, covers slippage and produces a profit that would beat most benchmarks. Despite this, a one tick average profit is often scoffed at by novice traders who shoot for the stars and end up with nothing. (To learn more, see Price Shading In The Forex Markets.)
Are You Undercapitalized for Making a Living?
Making only one tick on average seems easy, but the high failure rate among traders shows that it is not. Otherwise, a trader could simply increase the trade size to five lots per trade and be making 15% per month on a $50,000 account. Unfortunately, a small account is significantly impacted by the commissions and potential costs mentioned in the section above. A larger account is not as significantly affected. The larger account also has the advantage of taking larger positions to magnify the benefits of day trading . A small account cannot make such big trades, and even taking on a larger position than the account can withstand is very risky because this could lead to margin calls.
Because one of the common goals among day traders is to make a living off their activities, trading one contract 10 times per day while averaging a one-tick profit (which as we saw is a very high rate of return) may provide an income but factoring other expenses, it is unlikely that income will be one on which a trader could survive.
An account that is able to trade five contracts can essentially make five times as much as the trader trading one contract, as long as a disproportionate amount of capital is not risked.
There are no set rules on how many trades to make or contracts to trade. Each trader must look at his or her average profit per contract/trade to understand how many trades or contracts are needed to meet a given income expectation. How much risk a trader exposes himself to in doing this is also of prime concern. (For more insight, read Understanding Forex Risk Management.)
Leverage offers high reward coupled with high risk. Unfortunately, since many traders do not manage their accounts correctly, the benefits of leverage are rarely seen. Leverage allows the trader to take on larger positions than they could with their own capital alone.
Since traders should not risk more than 1% of their own money on a given trade, leverage can magnify returns, as long as the 1% rule is adhered to. However, leverage is often used recklessly by traders who are undercapitalized to begin with. In no place is this more prevalent than in the foreign exchange market, where traders can be leveraged by 50 to 400 times their invested capital. (Learn more about this in Forex Leverage: A Double-Edged Sword and Adding Leverage To Your Forex Trading.)
A trader who deposits $1,000 can use $100,000 (with 100 to 1 leverage) in the market. This can greatly magnify returns and losses. This is fine as long as only 1% (or less) of the trader's capital is risked on each trade. This means with an account this size only $10 (1% of $1,000) should be risked on each trade. In the volatile forex market, most traders will be continually stopped out with a stop so small. Therefore, in this market traders can trade micro lots, which will allow them more flexibility even with only a $10 stop. The lure of these products is to increase the stop, yet this will likely result in lackluster results as any trading system can go through a series of consecutive losing trades.
In this example, traders need to avoid the temptation of trying to turn their $1,000 into $2,000 quickly. It may happen, but in the long run the trader is better off building the account slowly by properly managing risk.
With an average five-pip profit and making 10 trades per day with a micro lot ($1,000), the trader will make $5 (estimated, and will depend on currency pair traded). This does not seem significant in monetary terms, but it is a 0.5% return on the $1,000 account in a single day. As the account grows the trader may be able to make a living off the account, but attempting to make a living off a small account will likely result in increased risks, excessive use of leverage and often large losses. (For more, see Forex Leverage: A Double-Edged Sword.)