“Trading is a very demanding and difficult activity that requires years of hard work for the minority who eventually finds success.”
Trading is a world filled with fantasies, especially that of quick money, traders driving Aston Martin or slashing Don Pérignon surrounded by beautiful women next to an infinity pool...
This is with those « clichés » that some unscrupulous people will try to convince you to buy a certain trading strategy or subscribe to a trading alert service promising huge overnight gains without any effort.
These foolish dreams quickly wither when you interact with people who trade for a living or when you have crashed your trading account in a few months believing trading is easy.
The people who make a living from trading are discreet, humble, hardworking and rarely show off.
Developing the idea that trading is easy is dangerous, let's face it. Trading is a very demanding and difficult business that requires years of hard work for the minority who eventually find success.
But what are the most common mistakes that new or unprofitable traders make, feeding the minority of those who learned (often at school of hard knocks) to reach consistency and performance ?
Here are the common pitfalls we must be aware of, at all costs, in order to become a profitable trader:
1-You think that trading is EASY
The barrier to enter the trading arena is very low. All you need is a small trading account, a broker, a computer and an internet connection. Finally, once you are about to place your first trade, you can consider that you have a 50% chance of winning and 50% chance of losing. The worst thing that can happen to the unskilled new trader at this point is to have winning trade right from the start.
Why? Because he will have the illusion that a fortune is waiting for him effortlessly.
He will repeat the experience without a stop loss, without a backtested strategy, without special knowledge and will literally pulverize his capital at a record speed.
Why would trading be easy? It is a special activity, of course, but a professional activity like any other except that the market eco-system is made in such a way that the majority of losers literally feed the minority of winners. This is why this is called a zero-sum game.
This is therefore more a competition-like activity than a traditional business. Would you ask a surgeon to operate on you if you knew he had not studied for a minimum period of the ten years required, had no experience, and had never operated on someone else before?
Would you ask a lawyer to defend your interests if he never litigated before and never studied law? Of course, no.
Trading should be viewed in the same way. To acquire expertise, whatever the field, you have to train and practice. Period.
2-You don't cut your losses and take yours gains too early
If you flip a coin and bet with a friend each time 1 dollar before each throw, you are certainly going to demand to win more than what you can lose or the game will not look interesting to you. This ratio between profit and risk is called the risk-reward ratio.
And we want to maximize it every time we play a game with uncertain outcome.
However, new traders forget very quickly this logical principle of risking less than the expected gain.
Indeed, human behavior comes into play. The newbie will take his gain very quick while he will let his losses slip hoping that his stock will recover.
He will develop a strategy with negative gain expectancy which will speed up his downfall ...
The emotional burden of loss has been shown to be greater than the pleasure or satisfaction associated with a gain.
In other words, we are less affected by a gain than by a loss.
This emotional bias which is called the loss-aversion bias and was first identified by Daniel Kahneman and Amos Tversky in 1979, causes a reluctance to take losses and encourage us to take small gains.
This bias makes us build, very naturally, a system with a negative gain expectancy. That means that if we follow this natural inclination, we are sure to lose in a more or less short period of time.
As a consequence, it is necessary to reverse the process by taking small losses and letting our gains run in order to magnify this famous risk-reward ratio.
At this point, it seems necessary to dismantle the most pernicious popular trading adage "a loss is not a loss until you sold" which decimates each trading day a great number of traders and installs us in a reassuring faulty intellectual and perfectly toxic comfort.
If I buy a stock at $10 and it trades a day later at $5, I lost 50% of my capital invested in that stock whether or not I sold it. $5 is what it's worth. Period.
What is more, a falling stock often tends to keep falling just as a rising stock tends to keep rising.
3-You believe that you have an edge without measuring it
To have an edge in the market consists in having a complete trading system that, trade after trade, makes money. To do this you need to start from a representative sample of trades, say 50, and calculate the expected payoff of your strategy.
The gain expectancy for each trade is given by this simple formula: ((% of winning trades * average gain) - (% of losing trades * average loss)*(position size per trade).
So there is a quantitative and cold step to take in determining if you have a real edge. If your trading gain expectancy is negative, you have no edge.
Of course you will find that you have a negative gain expectancy by just looking at your capital curve, but you have to precisely measure its components to assess what has to be corrected or adjusted.
For example, you can have a risk-reward ratio (average gain / average loss) of 4 (you bet $1 to win $4) which is objectively a good ratio but you only win 10% of the time (hit ratio) which is insufficient even with this relatively high risk-reward ratio (0,1*4-0,9*1=-0,5$).
Conversely, you can win 80% of the time and lose money. This is the configuration that is frequently found among new traders who seek to maximize the number of times they are right by forgetting the importance of the risk-reward ratio.
It is easier to capture a gain of 5% than a gain of 10%, a gain of 10% than a gain of 20% and so on so that we are naturally prone to maximize the number of winning trades at the expense of a low risk-reward ratio.
As a consequence, a scalper or a daytrader will have often and potentially a lesser risk-reward ratio than a swing trader or a position trader, which makes them more dependent on an high hit ratio.
Indeed, we have always been taught that the higher the percentage, whatever the situation, the better.
It is also this bias that the Française des Jeux (the french national lottery) used to promote its games, explaining that "100% of the winners tried their luck". Even if this is obvious, what you will remember is the percentage of 100% without giving much of importance to the meaning of the rest of the sentence.
In trading it doesn't work like that.
Even if you lose more often than you win, you can have a robust trading edge with a (high) positive gain expectancy.
Paradoxically, the most profitable strategies are often those with a low hit ratio and a high risk/reward.
In trading as elsewhere, this is a small number of very profitable operations (pareto law) which will make you earn money but to do this, you have to let your gains run and cut your losses very quickly. Even if you lose more often than you win, you can build a fortune by playing your edge on a regular basis.
In addition, this is a prerequisite to success to carry out a rigorous backtesting (manual or automated) to look at what your strategy would have done in the past and not just over the last 15 days. This will give you confidence in your whole trading system (and not only your trading strategy) and will encourage you not only to respect it every day but also to continue to apply it even in adverse market conditions.
4-You want to be right
As a human being, we want to be right. More broadly, we want to provide a fair answer to a question asked in class by the teacher, we want to impose our point of view during a conversation between friends (whether you accept it or not), we want to pass an exam, we want this marketing campaign that we are carrying out for our company to be a success, we want to succeed in seducing the girl next door, and so on.
We therefore want our actions to be in sync with our expectations and we all are reluctant to accept pain.
We fear to disappoint our teacher, we fear to be the object of mockery from our classmates, not to have the recognition of our boss, not to please the one we like.
To quote VAN K. THARP ”You don’t trade the markets; you only trade your beliefs about the markets.".
Let me explain. The market doesn't know you exist, so it doesn't care about your level of education, whether you're a teenager or an old man, if you are looking for recognition, admiration or love.
Often we consider, as we would in society, that the market owes us something good and reassuring, like the benevolent caress of a mother who consoles her child.
Suddenly we will judge inadmissible, see intolerable, to lose money on an operation that we had carefully studied and which allowed all hopes.
“This desire to be right results in rationalization, a process which can be profitable in everyday life but represents an invitation to disaster in the markets.”
This strong desire to be right or refusing to be wrong results in our inability to take our loss which will grow to the point that it becomes absolutely unbearable.
This will lead us to sell at the lowest price in sync with the mass of unprepared traders just to see our stock moving the other way just after.
Hence the feeling of always selling at the lowest price when you start trading ...
This desire to be right results in rationalization, a process which can be profitable in everyday life but represents an invitation to disaster in the markets. Why?
Because you will always find a reason why your stock MUST go up. Its operating results are excellent. You saw this company's product at the supermarket around the corner. Analysts are raving about it. We want to be right and instead of taking our loss and moving on, we see it swell and loss after loss we witness, helplessly, the inevitable destruction of our capital.
This is what we called « the confirmation bias ».
A paramount principle in trading is to never try to be right or try to explain the why and the how. The market is never wrong. We are the only reason of our failure.
As soon as the market moves, a slew of analysts and ourselves will try to find the why of this movement but is it important? NO. If the market or my stock went down 5%, the market or my stock down 5% that's all. The reason behind this, does not matter.
You absolutely have to follow what the market says without trying to rationalize. You have to follow the price without bias and without philosophical questioning. Your opinion plays against you and represents a permanent danger from which it is necessary to be freed.
What matters is to win more when you are right then you lose when you are wrong.
5-You don't understand that trading is all about probabilities
Most new traders are looking for “the stock idea of their life time” an unusual transaction that will make them rich in a matter of days or weeks.
And isolated trade will rarely change the course of your life but a succession of operations that you will carry out by applying a robust and profitable strategy with consistency, will.
“You want to be the casino, not the gambler who is sure to lose in the long run.————————————————————————————————————————————————————————
Any profitable trader knows that he will never know the outcome of every single trade. However, he knows that, and after of a significant number of operations, he will be a winner over the next month, year or 10 coming years. In other words, he knows how much he can earn after a large number of trades while ignoring the outcome of each individual trade.
You want to be the casino, not the gambler who is sure to lose in the long run.
Why would operators spend $4 billion setting up a casino in the middle of the Nevada desert when they will never know the outcome of every game, every bet?
Because they think in terms of probabilities and have understood the law of large numbers. They know, for example, that blackjack offers them an expected gain of 2.5% for each bet placed.
It doesn't seem like much but multiplied by hundreds of millions of dollars in stakes, they know they will win for sure and a lot on the long run.
This is why they hunt, for example, "manu militari" the card counters who "steal" this edge from them.
6-You underestimate the amount of work required
The great American football coach Vince Lombardi said: "Winners never quit, and quitters never win".
As it is often said, trading is like a competition sport. To succeed, you have to be among the best ones and this requires a drastic preparation. This preparation has many facets.
First, you have to read from those who have succeeded, you have to understand what to do to win in the markets.
Second, you have to develop a strategy that works for you.
Would you like to be a scalper and hold positions for few seconds or minutes?
Do you want to be a daytrader and close all your positions before the end of the trading session?
Would you like to become a swing trader by holding your positions for several days?
Would you prefer to run price movements for several months like position traders do?
Do you want to combine technical/chart analysis with fundamental analysis or only deal with price/volumes sequences?
And so on...
In short, there are as many strategies as there are traders. You must therefore find the time horizon and the style (fundamental or / and technical) that fits your personality, your risk tolerance and performance objectives.
Then, you have to trade, test your system, correct it, improve it until you become the undisputed specialist of your own strategy which will require only minor ex post adjustments, once established. Like a second nature ...
In this regard, great traders (the "turtle traders" among others) have written in black and white in a book their strategy with which they have earned millions of dollars. Were they afraid of losing their edge by doing so?
No, because he knew that a very small minority would be able to copy and replicate flawlessly what had worked for them.
“How can you consistently apply a strategy if you don't have absolute faith in your edge?”
It is an absolute myth to believe that there is a secret you should know in order to be successful as a trader.
To paraphrase a great trader "the secret is that there are no secrets".
This is the reason why and even if you don't have to reinvent the wheel and you can draw inspiration from the strategies of some big winners, trading is a highly individual and solitary activity.
How can you consistently apply a strategy if you don't have absolute faith in your advantage?
And to develop this edge, you have to test your system, discuss it, criticize it, test it in all market configurations and be able to accept times when this strategy will experience inevitable periods of underperformance like a business that encounters cycles of growth and periods of slowdowns in activity without having the temptation to change model as soon as the results are not there.
Developing a daily routine (the human brain likes routine…) will tremendously help you: market screening, backtesting, writing a trading journal to follow your progress, reading blogs, books, following a mentor on Twitter, etc.
In sport as elsewhere, it is said that it takes 10,000 hours of work and rehearsal in a specific field (piano, swimming, etc.) to be successful. It's debatable, but let's say that it takes several years of daily work to acquire real expertise in a specific field.
Trading is an activity recognized as requiring a "trial and error" approach.
You need a broad goal and jump into the water, see that it doesn't work then try something else by gradually making your way towards a robust, "imperfect" system, but which works, is profitable and resonates with your personality, your appetite for the risk and your performance objectives.
To prosper in trading is to espouse for life this adage which speaks for itself: "to progress is to go from one mistake to the next ».
7-You believe that finding a winning strategy is enough...
First if you have found a winning trading strategy, that is that provides a positive gain expectancy, you have to follow it with conviction and consistency.
Often novice traders change strategies as soon as their initial trading system ceases to produce positive results. But no trading strategy works all the time. Market conditions can change and you will find less opportunities and take more losses. This is the time to step back, reduce your position size and prepare for better market conditions, not to change your strategy and losing your expertise.
Second, a winning trading strategy is good but not enough to succeed in trading. You need a complete winning trading system to succeed.
I often hear traders who consult me in order to progress in their trading activity asking me for advice on the technique to adopt in the markets.
What if I told you that the less important subject is what you buy, the market you trade, when you sell?
These people know better than I the market in which they operate, the intuition they have developed there and the technique they use to buy or sell.
You may have an extraordinary ability to recognize price sequences that lead to strong advances in the security you buy and lose consistently in the market.
“A winning trading strategy is good but not enough to succeed in trading. You need a complete winning trading system.———————————————————————————————————————————————————————
You can have an unsophisticated, "average" strategy and earn a fortune.
What is important is not the technique. The important thing is to set up a complete trading system that defines the maximum risk taken per transaction and for your entire portfolio before any desire to win, which takes collective and individual psychology into account, which considers all the possibilities and more...
Believing that it is your technique that will make the difference is to be seriously mistaken and confuse the tree with the forest.
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