Trading Psychology

The following is a great article written by Marcus Padley . Every single destructive behavioural pattern explained can be overcome by a thoroughly researched and tested trading system provided that the system is followed religiously. It takes a lot of effort and knowledge to develop a good system, but unless you trade it as it is tested then you may as well not bother starting in the first place. I think new traders greatly underestimate how hard this aspect of trading is, mainly due to the cognitive biases explained in the article.


Tricks of the trade lead us all to feel rather than think
Marcus PadleyJune 20, 2009
MOST traders lose money. If you read some of the literature on the subject, the suggestion is that 60 per cent-90 per cent of traders lose money, depending on their level of leverage.
For retail investors, trading foreign exchange is apparently the biggest killer, followed by futures, options, CFDs (contracts for difference) and margin lending on shares. In one of these groups only 2 per cent make money and in another the average life span of a trader is six to eight weeks.
Why do so many people lose at trading? The answer is that they are humans not machines. Most traders do not think clearly and, faced with losses, gains, luck and indecision, they begin to function emotionally instead of mechanically. It is this weakness the studied professional trader takes advantage of.
This is what behavioural finance is all about. Over a large population and a significant period of time seemingly unpredictable emotions repeat, become predictable and can be exploited. For traders who understand this and trade against it, it is like owning the "zero" on the roulette wheel. An edge that will manifest itself over time.
So how do you stop other people exploiting your emotions? You change. But before you can do that the first step is to identify the common behaviour patterns that lose you money. Here's a list of some of the more common ones. In financial and social theory some of these are called cognitive biases, erroneous rules of thumb or common errors of judgement. In trading there are many. You might recognise a few of your own:
■Emotional bias — the tendency to believe the things that make you feel good and to disregard things that make you feel bad. In trading terms this means ignoring the bad news and focusing on the good news. It's called losing objectivity. You don't recognise when things go wrong because you don't want to.
■Expectation bias — the tendency to believe in things that you expect. In financial terms this means not bothering to analyse, test, measure or doubt the conclusion you expect or hope for. It is also known as the law of small numbers. Believing in something with little real evidence.
■The disposition effect — the tendency to cut your profits and let your losses run. The complete opposite of what a trader should be doing. Making small profits and big losses is a recipe for losses.
■Loss aversion — the tendency to value the avoidance of loss more highly than the making of gain. Losses affect you more than gains. Because of this you become more emotional when making losses, the point at which a rational decision would save you the most money.
■The sunk cost fallacy — this is the tendency for our decision making to be influenced by the size of the loss we have already incurred. The bigger the loss the more likely we are to persist with a losing trade rather than to take the rational decision and cut to a more profitable trade. The size of your loss has no effect on the future share price but a huge effect on your ability to make the right decision.
■The bandwagon effect — the tendency to think it must be right because everyone else is doing it. A thought process guaranteed to get you in when it's obvious and get you out when it's obvious. Put another way, it has you buying at the top and selling at the bottom.
■Past price fixation — this is the tendency to avoid prudent trading decisions by anchoring your thought process to prices that no longer exist. "I'll sell it if it gets back to $4." "I'll buy it if it gets down to $4 again." We are all guilty.
In trend-following trading, if the price goes up you don't sell you buy and if it goes down you don't buy you sell. The old high has gone. The old low has gone. Don't wait for them to come back to do the wrong thing.
It's not easy to be unemotional when trading but that's how we're all wired. To move from the losing majority to the winning minority we will all just have to unplug and reconfigure.
Marcus Padley is a stockbroker with Patersons Securities and the author of the daily sharemarket newsletter Marcus Today.
www.marcustoday.com.au

MRM still open

The MRM trade is still open and looking pretty good - prices moved past some significant resistance levels from back in October. However, I really don't worry about things like that. I know that every trade has about a 50% chance of being profitable. Notice also that the trailing stop is still only just above the actually entry price.

I have been mainly out of the market for about 18 months now due to other uses of my capital, and it is a bit frustrating to watch such a great bear market rally unfold. I have only just started to trade again with my small SMSF portfolio, but bigger things will have to wait for later in the year.