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Thursday, 17 April 2008

Trading Without Emotion

By TradingMarkets Research

Peter Forth is president of 4th Systems Inc. and creator of the StockReflex stock market replay simulator (stockreflex.net). Part video game, part learning tool, StockReflex helps you refine your technical analysis skills and amass trading experience without financial risk.

According to Cal Berkley University research, more than eight out of ten people who trade the stock market on a regular basis lose money. However, the people who do make money at trading tend to do so consistently and repetitively. What do these successful traders have that the others don't? A key factor is their ability to make their decisions to buy and sell without being influenced by extremes of fear and greed. Indeed, inappropriate emotional influence on trading decisions is one of the key reasons that most traders fail to make a profit.

Fear

There's a martial-arts maxim that you should never get into the ring until you have mastered the basic forms. If you do, your fear of getting hurt makes it almost impossible for you to objectively evaluate the situation and respond to it appropriately. So how does mastery of the basics stop you from being fearful? Most fear stems from being confronted with an unfamiliar situation and being unsure what the correct response is. By practicing and rehearsing situations, scenarios, and responses beforehand you can recognize them when you confront them in real life. Ideally you will have already tried solving the problem using several different tactics while in the safe zone of your training and should now have no hesitation in choosing the most appropriate and effective response.

This same principle applies to trading. How many times have you seen a stock you own spiral downward and thought, "Look how far it's dropped! I'd better get out now before it falls further and I lose all my money." Or if a stock you were considering purchasing goes up before you bought it said to yourself, "I'd better jump in now or I'll miss the boat completely!" With enough practice and experience under your belt you would be less likely to be scared into making the wrong decisions.

Greed

The flip side to fear is greed. Wall Street's Gordon Gecko may have preached "greed is good", but this is not necessarily true in stock trading. For example, greed can cause you to stay in a stock too long and watch the profits that you had acquired evaporate. It can cause you to misallocate your capital by putting too much money in a stock that has performed well for you in the past instead of properly diversifying your portfolio. And perhaps even more seriously, as Bears Stern's employees recently found out, it can encourage you to use too much leverage. Anyone who has tried this can attest that leverage is a double-edged sword. It can produce spectacular gains, but many investors who start out successfully become overly confident and begin to use more and more of it. Once this cycle begins, it's only a matter of time until the inevitable highly leveraged bad bet decimates the gains which have come before it.

Practice, Practice, Practice

Just like you shouldn't practice your basic martial-arts forms in the ring where your mind is more focused on pain avoidance then executing the tactic correctly, a novice shouldn't begin trading with real money and real consequences. Only once you've amassed significant practice in a safe environment where you can conduct your technical and fundamental analysis without being emotionally distracted should you begin to trade with real money. And when you finally start, don't jump straight into the ring with Bruce Lee. Begin tentatively, gradually, slowly increasing your trading exposure over time as you become accustomed to the increasing levels of risk. How do you know you've moved too far, too fast? If you are finding it's becoming harder to sleep at night, either because you are worrying about your trades or you are excited about your gains, then you have moved into the realm where your emotions are going to have too strong an effect. You are going to start making poor, emotionally-clouded decisions and so it is time to scale back.

Real-time Virtual or Fantasy Trading

There are hundreds of online systems that allow you to practice trading against the real markets using virtual money. These systems are useful in that they provide an automated way for you to keep score and track your trading progress without risking real cash, so you can keep your emotions in check. These systems allow you to practice both your fundamental analysis (choosing stocks based on fundamental market trends) and your technical analysis (trading using patterns in a stock's chart to tell you where the best entry and exit points are).

Replaying History

Real-time virtual trading is an incredibly valuable place to begin practicing emotionless trading but it does have one drawback - it has a fairly long feedback loop for your learning curve. That is, you can only learn as fast as the market itself moves, so sometimes you have to wait for weeks or months before you can evaluate if your trade was profitable or not. For traders who use stock charts and technical analysis but want to speed up this learning curve, one alternative is to replay historical data as if it was really happening.

For example, using your favorite charting software you could:

1. Pull up an old chart of a stock that you are not familiar with.

2. Cover up the last half of it and then slowly reveal it one bar at a time.

3. Pretend that you have sizeable position in the stock.

4. Be introspective and monitor your emotions as you reveal each bar.

5. Analyze the market by focusing on the present moment instead of trying to guess what's what up ahead.

6. Continually reevaluate the situation and ask yourself: Should I trail my stop to lock in gains? Should place a limit order to exit with a profit.

Should exit now and take a loss? What is the price action and my indicators telling me now?

7. In this way you can do analysis and make virtual trading decisions, and then tell almost immediately if you made the right calls.

Of course there are also several software packages on the market that automate this process by hiding the "future" part of the chart, asking you to make virtual trades and then tracking your results. Using tools like these you can potentially simulate a whole years worth of trading in minutes.

Black Belt Trading

The market can feel like a combat zone. It's a real challenge to keep your emotions from obscuring your judgment and influencing your moves. However, with the trial and error of practice and the hindsight of experience under your belt, you can eventually learn to approach your trading with the calm, cool deliberation of a skilled master.

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