In today's post from the series "The importance of ... in trading", XBTFX would like to take a look into trading psychology and why understanding that you are your worst enemy is crucial to your own success. We plan to produce a series of these posts and we hope that clients will find them useful and valuable.
There is very well known saying in poker "Poker is a hard way to make an easy living". Virtually the same applies to trading. Truth be told, the qualities required to be successful in poker and trading are very similar and most of the time it boils down to how well a person can handle his own emotions and how disciplined he is.
Very often people get fixated on the concept of being "right". Even Ray Dalio famously went virtually bust because he was shorting stocks in 1982. He was so sure about his prediction that he was very vocal about it. What followed was him nearly going bankrupt and having to obtain loan money. You can read a bit more about the story here : https://www.cnbc.com/2017/09/15/ray-dalio-went-broke-and-nearly-shut-bridgewater-hedge-fund.html
Here is an excerpt from the article :
...."In 1982, Dalio confidently predicted the global economy was headed toward a depression and he traded accordingly.
“I was dead wrong … The stock market began a big bull run, and over the next eighteen years the U.S. economy enjoyed the greatest noninflationary growth period in its history,” he wrote in his book entitled “Principles: Life and Work,” available on Tuesday.
“My experience over this period was like a series of blows to the head with a baseball bat. Being so wrong – and especially so publicly wrong – was incredibly humbling and cost me just about everything I had built at Bridgewater,” he added.
Due to the losses, the investor was forced to lay off all of his employees and ask for money from his family.
“I’d lost so much money I couldn’t afford to pay the people who worked with me. One by one, I had to let them go,” he wrote. “To make ends meet, I even had to borrow $4,000 from my dad until we could sell our second car.”
Dalio said he was too arrogant, overconfident and failed to do enough historical research..."
Dalio's story is a fairly common theme, as he outlined there are several elements to why this happened and they all rely on psychology:
1) Arrogance
2) Overconfidence
3) Lack of enough research
In order to remedy the above it is usually smart for traders to take a proactive approach at risk management. Instead of focusing on "being" right about a certain movement, defining clear levels of entry and exit can avoid the headaches that comes with what Dalio experienced. As a matter of fact one of our mentors at XBTFX used to say, "the primary goal of trading is not generating profits, it is capital preservation".
Traders should remember that no-position is also a position. There is noone putting a gun next to your head making you take trades every single day. Truthfully, it is a good rule of thumb to remember that initiating a trade because you need to generate profits is more often than not a bad idea. Trades should always be taken upon a careful assessment and upon the achievement of pre-defined criteria and conditions that give an appropriate trading signal. We highly encourage traders to define clear stop loss levels and clear take profit levels. Furthermore, we warn about the dangerous of re-entering the same positions over and over again after taking a loss. Instead, once a loss has been taken it is usually best practice to wait until a new trading signal has presented itself. Most of the time when a trader tries to re-enter the same position after a stop loss is trigger he ends up not only being stopped again but paying commissions twice.
It is useful to remember that trading profits usually follow the Pareto principle, which means that for most traders 20% of their positions will generate 80% of their profits.
With that regard it is important to remember that for most people dealing with loosing trades is more of an emotional experience than making a profitable trade. We have personally found that after a bad loosing streak instead of trying to make back the loss the best approach to new setups is :
1) Take less risk until comfortable with your trading. Often after a loosing streak traders will try to make back the loss by taking more risk, but this is inherently very dangerous. You are leveraging higher with less capital, which means the risk of total ruin is increasing.
2) If a trader is feeling a huge emotional drag its usually wise to take some time off markets. There is nothing wrong with walking away for a couple of days or weeks or however necessary to regain confidence and trust in your abilities.
3) Remember that loosing is part of this job and embrace it. Every trade is just a data point in a series of trades that hopefully results in an ever increasing equity curve.
Perhaps, most importantly we would like to remind everyone one of our favorite quotes by Keynes "The market can remain irrational longer than you can remain solvent."
Thus, our take is simple : don't get married to a position, don't over leverage, take positions only on a well defined basis with clear risk management. This in the long term will ensure success.
