When it comes to decision making in trading, I’ve three golden rules:
– Be prompt and decisive.
– Keep your risk small.
– Accept that you’ll get it wrong a fair percentage of the time.
The three rules are interlinked – they don’t work unless they are used together.
It’s extremely hard to be decisive if you’re risking too much – and the same goes for accepting that you’ll get it wrong. If your risk is too high, you can’t afford to be wrong (ever!)
In the same way, if you dither and spend ages over your trading decisions, you’ll probably want to risk more on each trade – simply because it takes you so long to get around to placing a trade!
While being decisive and keeping your risk small sound like sensible ways to trade… many traders have a problem with the idea that they should be wrong a lot of the time.
Surely, we should be striving to be “right” in our trading decisions?
Successful trading is about playing the odds so that you win more from your winning trades than you lose on your losing trades.
Provided you’ve balanced your odds properly, then you really shouldn’t care whether individual trades are “right” or “wrong”. In fact, focusing too much on the rights and wrongs of individual trades is likely to cause problems.
Let’s say that you’ve got a success rate of 40% (i.e. you win on average 4 out of 10 trades). And your win-loss ratio is 2:1 (i.e. your winning trades pocket £20 for each £10 you lose). You have a profitable strategy, yet most of the time (60% of it), you’re going to be losing.
And if you start adapting your strategy to avoid those losses, then you could be scuppering an otherwise profitable system.
Think of a Las Vegas casino – they generally maintain an edge of around 4.5%, which means that for every $1 that’s spent in their casino, they pay out 95.5 cents. Casinos don’t care who wins a jackpot, and who gets wiped out – as long as they can maintain their 4.5% average.
The markets don’t care what we “think” will happen. Just as a roulette ball doesn’t give a damn about where the punters place their money.
And the casinos don’t worry in the slightest about where the ball will fall… or which card is drawn next.
What matters are the odds, and as long as we have a successful strategy, the odds will always pay out in the end.
So, we need to try to think like a casino (not like a gambler).
The casino analogy is a nice one, but, there’s something that this doesn’t take into account…
Casinos have an advantage that financial traders don’t – they know the exact odds of the roulette ball falling on evens … or how many queens are in a pack …
While the trader has carefully calculated odds based on a meticulously kept track record … the markets don’t care that you’ve got five years of backtested results showing that this strategy has a 61% success rate, with a 1:1 risk-reward ratio.
I’m talking about something that’s not often discussed in trading circles.
Because it makes traders feel decided uncomfortable.
It’s the ever-changing cycles of the market – just as a pattern of behaviour shows itself, the market behaviour changes, and new patterns emerge.
It’s why trading strategies produce great results for months or years, and then suddenly seem to switch off – the pattern they were relying on has ended.
For those of us who desperately want to find a trading “holy grail”, it’s a tough lesson to take on board.
But it explains the exasperation we feel when our winning strategy suddenly gives up on us.
However, we have to be realistic here – if there was genuinely a “holy grail” that could stand the test of time – everyone would be doing it! (And, yes, the pattern would have to change.)
That’s why trading is a job of constantly looking for the “next thing” … a way of trading that matches the current “cycles”…
Yes, it’s frustrating as hell when it’s not working.
But the rewards it can reap make it all worthwhile.
And, if we understand and accept that the cycles of the market change, then perhaps we won’t feel quite so frustrated by technical indicators that mysteriously stop working and seem to give false signals again and again.
Just pop them up on the shelf, ready to dust off when the cycles change again …
In the next seven days …
It’s been a very unusual week for the markets, with Wall St missing for the first two days. The markets seem to have shaken off hurricane Sandy, but there’s no getting away from the jitters about this afternoon’s employment numbers.
Obama will be sweating these ones too – this is the last big economic release before the election, and it’s a crucial one. Last month’s big jump in employment figures was derided by the opposition as rigging – so it could be a tough one to win, either way.
While Tuesday’s presidential election will dominate news next week, there will be some other events going on around the globe (yes, really!)
Next week sees the usual monthly round of PMI releases, plus we have manufacturing and production data from the UK and the Eurozone. These are expected to show some positive movement, hinting that the UK and German economies are picking up.
The market’s reaction to this could be mixed. There’s some expectation that the Bank of England will announce more quantitative easing in its statement on Thursday. If the figures are looking too upbeat, then this could be in doubt. Certainly members of the Monetary Policy Committee seem to be cooling on the idea.