Thoughts on Trading Strategy

Over the past few weeks, we've had a number of discussions on trading strategy. In this article, I'd like to reiterate some thoughts, and add some additional key points:

1) Know your exit before you enter a trade.

Once you're in the trade, your emotions take over and you will tend to compound any mistakes. Awhile ago I wrote an article which discussed Prospect Theory. For those who missed it, Prospect Theory found that people become risk-averse when it comes to protecting gains, and risk-seeking when it comes to recovering losses. In other words, the natural instinct of people is the exact opposite of what it takes to be successful: most close their winners too early, and hang onto their losers way too long. For the record, it should be: Cut your losses, and let your winners run. To a point, anyway. That brings us to:

2) Don't be a pig.

Everyone's heard the expression, "Bulls make money, bears make money; pigs get slaughtered." This refers to the greed factor. Have you ever watched a winning trade turn into a loser? If you haven't, you've never traded. This happens because, the majority of the time, the market covers the same price territory repeatedly. If you get too greedy (piggy!), you'll watch many of your winners die, along with your account. That brings us to:

3) Develop a system to protect profits.

Once your trade is in profit, how are you protecting that? Do you move your stop-losses? At what point do you close your trades and take profits? Are you being a piggy! and just hoping for more and more? You should design a system that allows you to take at least partial profits at certain times. As an example, years ago when I traded options frequently (which I don't anymore), I used to close half my position whenever the value doubled no matter what. That allowed me to guarantee I got all of my capital back (50% of 200% = 100% of the original investment). After that, I was in the remainder of the position for "free," which allowed me to manage it much less emotionally. To use casino terms, I was playing with the house's money. I'm not suggesting this works for everyone, but it worked well for me. The larger point is you need some type of strategy that you can stick to with discipline. That brings us to:

4) Protect your capital.

As a trader, your capital is your life's blood. It's everything. If you have no capital, you have no income. There is no worse feeling than blowing up your trading account, and I speak from first-hand experience. Back in 2002, when I was less experienced at trading bear markets, I over-leveraged myself into short-dated puts at exactly the wrong time, and blew up my account to the tune of six figures. I had decided to try and "knock one out of the park" -- and I did it at just the wrong time. As a result of this experience, I am now much more careful trading leveraged instruments, especially options. If you're taking excessive risks with your capital, you might consider that living to fight another day is irreplaceable for a trader. That brings us to:

5) Discipline must trump conviction.

Another tendency we all have is to "marry" our beliefs in life. This can be death for a trader. Maybe we believe the market is due to fall because jobless claims came in showing that unemployment just hit 50%, and the ECB just announced that they're going to start holding public executions of Prime Ministers, and Ben Bernanke just gave CNBC the finger. The market doesn't care what you think should happen, even when what you think makes complete sense. The market is often completely irrational, because there are factors at play that have absolutely nothing to do with fundamentals. So one has to respect the price signals, and one has to be willing to exit a trade with discipline, even when one's conviction says otherwise. That brings us to:

6) It's rarely smart to "bet the farm" on one play.

Unless you're the World's Greatest Market Timer (hint: you're not), it's usually a good idea to scale your way into trades. If you bet it all on one entry, you leave yourself no room to be wrong and average down. You are also putting a ton of psychological pressure on yourself if your position doesn't perform immediately.  Keep the size of your positions reasonable; don't bet so much of your account on one play that you can't recover.  And as I've said many times: your first opponent as a trader, and the hardest opponent to beat, is yourself. That brings us to:

7) There's no such thing as "missing" a move.

How often have you missed a limit entry by some miniscule amount, and then kicked yourself as you watched the trade you're not in move in the direction you thought it would? Or missed an exit by a small amount, and then watched your profits start to vanish? It happens to all of us. Both of these situations have the potential to turbo-charge your emotions, which makes you prone to mistakes.

It's human nature to hate feeling "left out" and like we missed an opportunity. I believe this somewhat immature emotion is a vestige of childhood. One of my first experiences of the fallacy of "missed opportunity" came when I was eleven-years-old: my friend was going to Disney World, and I was invited to go with him... but my parents refused to pony up the cash. I remember getting quite upset about it and telling my father that I had missed a "once in a lifetime opportunity to go to Disney World." That's actually how I felt, at eleven. My father, to his credit, burst out laughing. Needless to say, a few years later I went to Disney World -- a second chance at that "once in a lifetime" opportunity. I've been to Disney World three times since. As an adult, I realize that considering Disney World to be a "once in a lifetime" opportunity is completely silly. The same goes for that trade you just missed.

Obviously, the market will still be there tomorrow. So why all the frustration over "missed opportunity"? I believe the majority of it boils down to the desire for instant gratification. We start kicking ourselves over the money we "could've" had right now if we'd made the trade. A trader can't afford to give any quarter to this type of thinking. Trading is like everything else in life that's worth doing: it's not a sprint; it's a marathon. Patience is key. The very human desire for instant gratification must be controlled with discipline; and the self-indulgent poor-me emotion of "missing out" must also be controlled with discipline. If you can't control the emotions, walk away from your computer and come back when you can, because otherwise you're going to make bad decisions for your next trade.

In the long run, if you lack discipline, you may make some winning trades and win the battle of market direction at times, but you will ultimately lose the war. That brings us to:

8) Trading is war.

Make no mistake: trading is a fight to the death -- not only against your own emotions, but against the other market players (financially, anyway). The Japanese have a saying, "business is war" -- I believe this absolutely applies to trading as well. You are the general, and your positions are your troops. Are you deploying your troops at random, in a haphazard fashion? Are you "hoping" they can win, when they are outnumbered by superior, better-equipped forces? Your enemy has done extensive reconnaissance, developed a solid strategy, and deployed his troops accordingly. What's your strategy to beat him? What's your plan for retreat if the battle is being lost? If you don't take it that seriously, how can you hope to win against those who do? That brings us to:

9) Refine your strategies by paper trading. Save your money until after you have a plan.

Don't send your troops off to get slaughtered while you try to figure out what you're doing. Paper trading is a great way to help develop and test trading strategies without it costing an arm and a leg to do so -- and without needing to sit by your computer armed with several bottles of Mylanta.



Of course, there's always more that could be said about trading strategy -- but I was attempting to write an article, as opposed to a book. ;) As always, trade safe!