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Let’s face facts. Stuff happens. Sometimes it’s good stuff; sometimes it’s bad stuff. Regardless, in most cases it is not the event that happens itself but rather how we react to that event that matters most. Ultimately, perception is reality. If someone hits our car with their car we could tell ourselves, “Well, that’s what insurance is for,” and calmly set out on the process of obtaining restitution. An alternative – and more common - response is to jump out of the car screaming and waving one’s arms, while not quite so calmly inquiring to the other driver just exactly the “@#$%& were you thinking about!”  Sure it is a stressful situation – and anytime insurance companies are involved anger is a natural response. Still, the point is that in almost all cases we have a choice as to how we react. Since so much of trading is simply an extension of everyday psychology – or in some cases, psychoses – the fact of the matter is that here too we have a choice as to how we react to favorable and unfavorable events. Consider a simple, average, everyday, run-of-the-mill losing trade. Some traders – upon getting stopped out at a preset price level as part of their money management technique - will essentially shrug their shoulders and say “Oh well, it happens.” Others will react as if, well, someone had hit their car with another car. The same anger, the same language, the same decibel level, and often including the same arm waving histrionics.

Same event. Two very different responses. In the end, “It’s all in your head.”  

THE TALE OF TWO TRADERS

Consider the following scenario. Two traders – Trader A and Trader B - are given the exact same trading system using the same objective rules guaranteed to generate the exact same buy and sell signals (and for argument’s sake, let’s say that the system makes at least some money just about every year). In addition they are guaranteed the exact same fills and commission rates. Lastly they are both given $100,000 with which to trade. So given this scenario, what are the probabilities that one year from now these two traders will have generated the exact same rate of return?  Think about it for a moment.

Okay, time is up. My best guess – about a billion to one. Why is the likelihood so low in my estimation?  Because, as I mentioned earlier, it’s all about what you think. Or more precisely in this case, it’s all about what Trader A and Trader B think. At some point Trader A may get “bored” following a mechanical system and will decide to apply his own “filter” to the system. Likewise, after three consecutive losing trades Trader B may decide to “sit out” for a while and wait for the system to “start working again.” Or he may go the other way and decide to increase his trading size in an effort to recoup his loses more quickly. In any event, in the real world it is highly unlikely that both traders will blindly follow the “boring” mechanical system indefinitely.

CAN A WINNING TRADE BE A BAD THING?

This is a question I like to ask traders from time to time. Think about it for a moment. Can a winning trade ever be a “bad thing”?  Some individuals quickly sense a trick question and say “Yes.” But the majority of traders will typically give it some thought and after a little reflection will conclude something along the lines of the following – “No, profits can sometimes be tough to come by. So anytime I make money that’s a good thing.”  To which I quickly reply, “Ha, you’ve fallen for my trick question (do I know how to have fun, or what?).”

To illustrate this point, consider the following futures trading scenario. You are thinking about buying soybeans, or even better, your mechanical system tells you to buy soybeans, but you hesitate. And suddenly bean prices start screaming higher, leaving you in the dust. Afraid to “chase the market” you start girding yourself to “buy on the next pullback.” And finally bean prices experience a correction. Wanting the correction to fully “play out” before jumping in, you miss the low and once again find yourself watching soybean prices rallying sharply. Finally after a few more strong up days you say, “Oh what the heck” and buy. Finally you are in and much to your pleasure price continue to advance and you feel some contentment at the fact that at least now you are “making some money.” But your “joy” is short-lived. After peaking a week later, soybean prices now begin to decline in a fairly unforgiving manner. Panicked, you dump your position. And when the dust has finally settled you realize that although soybeans rallied the equivalent of $5,000 per futures contract from low to high, you managed to extract a profit of all of $250!  Is this a “good thing”?  Think about it some more. 

Now here’s the paradox. Technically, yes it is a good thing because you have added $250 to your trading account.  In addition to that however, you have also potentially added a great deal of “emotional baggage” to your trading psyche. The memory of this “profitable” trade is likely to stick with you for some time to come. The next time you may buy too soon. Or sell too soon. Or hold on too long. Or whatever. You get the idea. Just as generals are often accused of fighting “the last war,” traders too often can give recent disappointments too much weight when making new decisions. So pay close attention to your reaction after stressful market events, regardless of whether or not you made money in the process. 

SETTING REALISTIC EXPECTATIONS

Occasionally someone new to trading or someone embarking on a “new and improved” trading campaign will ask, “How much should I make? 100% a year? 200%? 1,000%?  What’s a good rate of return?”  My common response is, “what are you making now?  First try to top that. Then go from there.”  So far no one seems to like that answer. Even worse, for people starting in futures or options, my advice is even more blunt. “During your first 12 months, just try to make money, period. Focus more on refining and implementing your methods. In other words, try to learn more about what it is you are doing.”  People really don’t like that answer. But the fact of the matter is that realistic expectations can be a new trader’s best friend. Why is it that people expect to open a trading account and just be a natural at trading and make more money than Solomon?  (Hint: the lure of easy money.) I mean, if you sign up to learn karate, when you show up for the first class are you ready to take your black belt exam?  It’s the same with trading. As it is the same with most all complicated endeavors. You first have to know what you are doing before you can do it well. This concept seems so obvious, yet too many traders don’t want to hear it.

A FEW REALITIES OF TRADING

1. There Will Be Losing Trades

I once worked with a broker who offered his new clients a “guarantee.” He told them “I guarantee you there will be losing trades.” People didn’t like that one a whole lot either. Yet in his own slightly comical way he did his clients a huge favor by stripping away any pretense that everything was going to be strawberries and champagne. Losing trades are a part of trading. Consider them a “cost of doing business.”  As such, the proper response is not to sit around hoping that losing trades don’t happen, but rather to plan for them in advance and ensure that you are doing everything you can to keep losing trades to a manageable level.

2. The More You Prepare, the More Successful You Will Be

I recently had the opportunity to work with Optionetics founder George Fontanills on a project, and the thing that struck me more than anything else from our discussions was how hard he works at trading. While I am not advocating that everyone try to put in the hours that he does, the point is simply that I believe the reason that he enjoys more success than many other traders is simply because he works harder at it. Remember, no one makes money trading in the long run because he or she is “lucky.” A little luck sure helps now and then, but ultimately it comes down to painstakingly applying a winning approach day in and day out.

3. You Must Prepare for the Emotional Impact of Losing and Winning Streaks           

Most individuals who have traded for any length of time are well aware of the emotional impact of losing streaks. They tend to eat away at you and if they extend long enough can lead you to wonder why you ever started trading in the first place. It is critically important to at least estimate prior to starting a trading campaign how much of a losing streak or drawdown you are likely to have to endure given your particular trading method and size. A decline in equity that is larger than you had anticipated can ultimately prove debilitating. This is a case where setting realistic expectations come in handy. On the flip side, most traders will of course welcome winning streaks. Especially an extended winning streak. Yet these streaks also can have an unexpected impact on a trader’s psyche. Once you have experienced the bliss of a period of “making easy money,” it can be that much harder to endure the next flat to down period. Likewise, it is critical to long-term success to not be seduced by an extended winning streak into thinking that you’ve got “the touch.”

SUMMARY

Think about it.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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