Monday, December 18, 2006

Three Pieces of Trading Wisdom

Over the years, I've been the fortunate recipient of much good trading advice and wisdom from those far more experienced in the markets than me. Here are three gems that have stood me in good stead in up markets, down ones, and everything in between:

1) Focus on being profitable for the week - Individual trades may go against you and individual trading days can offer little opportunity. As a senior trader once explained to me, for the active trader, however, there are enough fresh opportunities in a week to make it reasonable to set a goal of being profitable for the week. You won't reach your goal every single week, but the mere act of setting the goal keeps you focused. For example, you don't want to lose so much money in a single day that you can't make it back during the other days of the week. You also don't want to lose so much money on a single trade that you can't come back during the remainder of the day. When you really push yourself to be profitable every week, you don't let individual days get away from you. And when you don't let individual days get away from you, you start managing each trade carefully to ensure that your largest loss won't exceed your largest gain. Time and again I've seen a consistent sign of progress among developing traders: they stop digging themselves into holes.

2) Take what the market gives you - Today I peeled out of several short positions after a spate of very negative TICK readings in the afternoon. I've learned that such concentrated selling often precedes nasty short-covering rallies. My S&P position hadn't made as much profit as my NASDAQ and Russell positions, but the market doesn't care about that. I took what the market gave me and started the week green. Did the market go down even further after I exited? Absolutely. As one experienced trader explained to me, when the market rewards your position right off the bat, you want to take something off the table. You might let a piece of your position ride if you have a longer-term opinion, but never give green a chance to become red. A winner that turns into a loser is a double loss.

3) Always have something to "lean on" - Scalpers will notice heavy and persistent selling at a certain tick, accompanied by large offers in the order book. They'll lean on that information to find a good entry to sell the market. If the offers disappear from the book or if new buyers start lifting those offers in size, they can get out quickly. Knowing you have something to lean on, however, allows you to ride out the noise between entry and exit. As long as what you're leaning on doesn't vanish, you stay with your idea. Today I leaned on the inability of the Russell to make new highs on Friday. When we got some morning buying, but could not break above the early AM highs (and also above Friday's highs), I added to my shorts and vowed to stay short unless we broke the highs with expanded buying. Leaning on the pattern of Russell weakness enabled me to stick with a good trade idea during a choppy morning.

So let's restate the pieces of wisdom in reverse order:

1) Before you put your capital at risk, have a well-formed trade idea;
2) When your idea pays you out quickly, take some profits;
3) Don't get caught up in individual trades; focus on profitability over a series of trades and days.

I know, I know. These things sound ridiculously simple. But it's only been in the last couple of years that I can look myself in the mirror and say that I'm doing all three consistently. The spinning reverse dunks get the attention in basketball; the long touchdown pass makes the evening replays; and the big winning trades are the ones we like to talk about. The greater part of success, however, boils down to Xs and Os on the basketball court; blocking and tackling on the football field; and following basic fundamentals about framing and managing trades. It may not be sexy to execute on the fundamentals, but it gets the job done day after day and builds a career.

13 comments:

Anonymous said...

I especially like #2.

My motto for the past few years has been the old adage "No one ever went broke making a profit".

In reference to your short covering today (which I did likewise); when you take an early profit on a short trade and the market keeps going down. Instead of being bummed that you're missing out, think of it as your cash is doing better than the downward market.

...and you're right, the winners that turn to losers are especially painful.

Cheers

Ted said...

As a poker player, I strongly disagree with 1 and 2.

Where you are relative to your goals should not affect your decisions. If a trade is good, execute it. The fact that it's Friday and you're already up $1,000 this week should be irrelevant.

Also, how much money you've made from a position should not affect your decisions. Either a position is profitable or not. The point at which you entered shouldn't affect when you sell.

There are very analogous situations in poker. It's a mistake to play differently if you are up or down a bunch of money. Some bad players will make the mistake of playing very passively on their last orbit, if they know they're about to get up and go home. This is because of the psychological tendency to want to book a win. Our minds aren't mathematically inclined enough to weight wins and losses. But changing the basis for our decisions on conditions that don't affect the poker game (or the market) is stupid. We hurt our expecation in order to get a psychological gain.

yinTrader said...

Hi Brett

I thank you for sharing your knowledge or gems on trading well on a platter, virtually.

We all need this reminder from time to time.

Merci.

Brett Steenbarger, Ph.D. said...

Hi Marc,

Thanks for the note. Because there are such strong reversal tendencies in the stock indices, I find it helpful to take some profits when the market moves my way, even as I might leave a smaller, core position on for a larger move. I find it very much helps my mindframe to be in the mode of harvesting profits regularly.

Brett

Brett Steenbarger, Ph.D. said...

Hi Ted,

I actually agree strongly with what you're saying. If a trade has good odds, you have to go with it. What I won't do, however, is raise my bet size so large on that single trade that I could be blown out for the week or month.

How much money you've made from a trade affects your decisions only insofar as the move that made you money now shifts the odds of future directional movement. You can estimate the average size of a market move for any time frame based on historical norms. Once you're past that average size, you're running increasing risk of the market reversing against you. It makes sense to take some profits when the market has given you an unusually good-sized move. Very often, the odds in your favor have shifted measurably once the market has moved quite a bit your way.

Your basic point about poker and trading is right on. There are many great lessons from poker that can be applied to trading. Thanks for the comment--

Brett

Brett Steenbarger, Ph.D. said...

Thanks, Yin; I appreciate the feedback.

Brett

Anonymous said...

Ok, I have to agree with Ted in the general sense that performance relative to the goal shouldn't affect the trading plan.

However, for people like myself it does make a difference. There is an unknown quantity to the market. Institutions and hedge funds can move things contrary to expectations. Unforeseen news can totally screw up a very sound game plan. Taking a good profit relative to my usual trading allows me to pause and reassess the market. If it looks good, I can get back in. I don't like using stops or hedging with options so I'm somewhat exposed and I don't like leaving things sit too long. It's also fun to book a nice profit.

Plus my wife likes hearing that I made money today.

Marc

Anonymous said...

Great post and a great new book!

Today is an example of something that maybe you can look at % wise:

where the $RUT.X is down -1% and the $DJI is flat or even green!?... what are the returns over the next periods (days, weeks,months) for both indexes?

frustrating being short YM and not move, but see the ER2 lose 11

Anonymous said...

"It may not be sexy to execute on the fundamentals, but it gets the job done day after day and builds a career."

Absolutely beautiful.

Love your blog, it keeps me awake!

Brett Steenbarger, Ph.D. said...

Hi Marc,

The challenge is to do what's right for money management *and* what's right for our own psychological management. Sometimes there can be a tension between those two. Clearly, however, it's a mistake to get so caught up in the results of the last few trades that we miss opportunity or overtrade a market when we think we're hot. Thanks for the note--

Brett

Brett Steenbarger, Ph.D. said...

Thanks, Mike, for the comment on the book and the idea about the pattern between the small caps and the Dow. That theme has been critical over the last few weeks. I'll look into some research on that--

Brett

Brett Steenbarger, Ph.D. said...

Thanks Fredrik,

I'm glad the blog keeps you awake...sometimes it also prevents me from sleeping!! I appreciate the comments--

Brett

Rick said...

Dr. Steenbarger,

Great subject for a post. You touch on an area of trading that often puzzles me, as a relative newcomer.

Often I hear traders who are in a move say that they wouldn't recommend chasing it at this point, but they are also not going to exit their position. It seems to me that the risk:reward is the same whether you're in the position or not (the stock/ETF doesn't care that you are in!) If the move is exhausted, why is it OK to stay in if you're in but not advisable to enter the position if you are flat?

Is this more an issue of psychology and trade management than it is of actual probabilities?

Thanks for the great work! Looking forward to your book in my mailbox soon.