Sunday, May 3, 2015

Reasoning and Trading

In many situations we face in daily life, we recognize that action must be guided
by reason. Thinking is a powerful antidote to impulsive behavior. A perfect example is
the breaking of habits. We learn to overcome compulsive eating or drinking by making
ourselves first think about the consequences, then consciously choose an alternate course
of action. Without clear thinking about priorities, it is far too easy to fall into patterns of
behavior that offer short-term rewards but longer-term consequences.
So it is for traders. Having worked with dozens of traders over the past year, I
can vouch for the fact that, among active market participants, overtrading is the single
most common problem they face. Overtrading in this context means putting trades on
where there is no explicit edge—and even no valid rationale—for the trade. Generally,
the reasoning behind the excessive trade is nothing more than, “I felt like it was going
up.” What the impulsive trader fails to realize is that this is no different from the dieter’s
excuse, “I felt like eating the chocolate cake.”
A common occurrence for me is that I will go into a trader’s room and observe
him/her trade. Although the trader may be struggling and losing money every day,
generally they make money while I am watching them. This is not because I am offering
such grand market insights; usually I do not impose my market views on a trader. Rather,
I require the trader to verbalize the reasons behind his or her trade. This has the natural
effect of slowing down their trading and making them distinguish between genuine trade
ideas and mere trading impulses.
From my vantage point, all trading ideas boil down to variations on two themes:
1. The market is trending, and we want to buy pullbacks in an upward trend; sell
bounces in a downward trend;
2. The market is range bound, and we want to sell moves toward the top of the
range once buying dies out; buy moves to the lower end of the range once selling
dries up.
If I am employing solid reasoning in my trading, I want to assess the status of those
themes in both the time frame that I am trading and in the larger time frame. A trend in a
shorter-time frame may be part of a range in a longer frame; a range in the short time
frame may be a consolidation within a larger trend. Not infrequently, your ideas
regarding targets for a trade will come from the assessment of the larger time frame.
A sure-fire way to identify impulsive trades is by their absence of a well-conceived
exit. Ninety percent of the effort is going into getting into the trade—the entry—because
the purpose of the trade is to be in the market, not to make a profit. The impulsive trader
seeks action, not results. Because exits are associated with the cessation of action, they
get short shrift.
Conversely, the reasoned trade contains several components:
1. An assessment of current price behavior: Is buying pressure expanding or
contracting; is selling pressure expanding or contracting; is price volatility
expanding or contracting?
2. An assessment of market conditions at shorter and longer time frames: trending or
3. A target for the trade: A move to new highs/lows for a trend trade; a move toward
a price mean for a bracketing trade.
4. Criteria for stopping the trade: Conditions that will convince you that your trade
idea is no longer valid
5. A decision of resource allocation to the trade: How much of your capital you are
willing to put at risk on the trade idea.
If talking these five components out loud before each trade would lead you to trade
less often and would lead you to trade far differently from how you’re currently trading,
there is a likelihood that you are overtrading. There is definitely something to be said for
having a feel for trading. That doesn’t mean, however, that feelings substitute for market
knowledge and awareness.

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