For readers who haven’t been following this series of posts, it makes sense to read these posts first:
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Investing is less a field of finance and more a field of human behaviour. The key to investing success is not how much you know but how you behave. Your behaviour will matter far more than your fees, asset allocation, or analytical abilities. That is another way of saying that how you respond to the inherent market volatility is what matters. The following are my insights:
Journaling of Trades
- The structure of the journal is a very subjective topic. Broadly, one should be meticulous in keeping comprehensive write-ups on every trade, the significant trades that were missed. The idea is to, rub our nose in our mistakes; only then will we learn from them, not otherwise. One can then make a trading plan for both the execution and management of an anticipated trade.
- At the end of each month, it is a good idea to review the trade summaries for the prior month. Analysing past trades is essential. This is part of the journaling process. For example, while analysing past trades, one should be able to answer questions like (1) did I have a very clear reason for entering into the trade; (2) did I have a defined time horizon; (3) was there a protective stop and (4) depending on the outcome of the trade, was I right for the wrong reason, or vice versa.
- The words bullish or bearish don't mean anything. What matters is the person's time horizon? And what kind of a price move is one looking for and what kind of a move would overwhelmingly point at a mistake in one's premise. Writing this out before one enters a trade and if possible before exiting the trade, will bring about a noticeable change in trade outcomes.
- By maintaining a Trading Journal we can become aware of our automatic response patterns. As the emotional state becomes more excited, the magnitude of losses creeps higher. Eventually, it all comes down to your state of mind - which is the most critical factor to trading success. Mental capital is the most critical aspect of trading. What matters most is how you respond when you make a mistake, miss a trade, or take a significant loss. If you respond poorly, you will make more mistakes. Always respect the marketplace, never take anything for granted, do your homework, recap the day, and figure out what you did wrong and what you did right. One is homework and the other is projective. What do I want to happen tomorrow? What happens if the opposite occurs? What happens if nothing happens? Think through all the 'what ifs', anticipate and plan, rather than react.
- Do more of what works and less of what doesn’t. Just stop doing the things that are not working. Dissect your P&L and see what works for you and what doesn’t. It is a very interesting process to analyse where your profits come from, and traders often don’t know.
- When we do a trade that works, we must ask: why did it work, what did I do here, that I might be able to do in another market at another time? Trading involves a lot of reflection and that is something that most traders don't do. One has to do a lot of thinking before one trades.
- Winning trades tend to be in the money almost immediately or rather out stops are never threatened at all. Contrarily, Losing trades tend to go offside very fast and more often than not, tend to stay offside. The moral of the story is that we should study our winning trades, and do more of what works and less of what doesn't.
- The balance between luck and skill is tilted to the luck side when we trade or even invest in the stock market. You can't lose money on purpose especially when you’re trading. Many times we end up making money on a trade, but our reasoning is faulty (and the inverse is also true). Suppose you bought a stock because you felt that it has some upside over the short term (or vice-versa). If it goes up, you'll probably assume your skills as an astute trader are a reason. But if it goes down, it must be bad luck. Contrarily, judging the same outcomes faced by another investor, you'd be more likely to attribute the bad performance to a lack of skill than luck. The point is, that your interpretation of any situation will depend on your perspective. And, journaling your trades, brings perspective.
Money as a device for keeping score
- To be successful as a trader, you have to have a total disregard for money. You can't trade for money. You can't translate the money into real terms or in material terms. Winning traders have less fear than losing traders. Once you start thinking about money, you're dead.
- The best way of handling losses is to get out of the trade. Money is only a means of keeping score. Most traders tend to think of gains and losses in terms of their monetary implications - a frame of mind that only gets in the way of making trading decisions. It is one thing to get out of a trade because you don't like the position, it is another thing to exit a trade when you define the profits and losses in material terms.
- To be successful at trading one has to be willing to change one's opinion. Lose your opinion, not your money. Strong opinions weakly held is the mantra.
- Most people are afraid of making money than losing money - that's why they want to sell a stock that is up by 20 per cent. If a stock is down 20 per cent, they are not going to sell. What they are really afraid of is not being right. If they sell when it is down it will confirm that they were wrong and that is difficult to accept. Learning to separate one's ego from the need to make money is the key to being successful in the market. One has to accept that one can be wrong. For some people it is more of a problem accepting that they are wrong and they would rather lose money than accept such a thing; that is the wrong mindset in this business.
- Ed Seykota a legendary trader has made a profound statement: Everybody gets what they want out of the market. Many a time we put on a trade for no apparent reason. It could be due to complacency, a recovery trade, or just the urge to put on a trade (trading is addictive). In all such cases, we don't care about trade outcomes and are willing to lose money. And sure enough, that is what you'll end up doing. The moral of the story is that you don't always have to be in the market. Don't trade if you don't feel like it or if trading doesn't feel right for whatever reason. To win in the markets you need confidence as well as the desire to trade. Exceptional traders have these traits most of the time; for the rest of us, they come together only on an occasional basis. To make money, you have to hold a position with conviction. And that is very difficult to do when you follow someone else. That is why listening to others doesn’t work, and eventually, everyone ends up getting what he or she deserves.
- Good money management with a poor strategy can only ensure that you lose money more slowly. And, of course, a good system with poor management can lose money.
Emotions & Mindset
- Most of us can't control our emotions or follow a system. If you do make a mistake, don't complicate it, just get out. Most traders who fail have larger egos and can't admit they are wrong. Some traders fail because they are too worried about losing. When you start being afraid to lose, you're finished.
- Never be greedy, it's ok to leave money on the table. If you can't get a favourable price, let the trade go. Only by thinking independently can a trader hope to know when a trade isn't working. If you ever get tempted to seek out someone else's opinion, it is a sure sign that you need to get out of your position.
- Anyone who wants to trade must learn not to take a loss personally. The markets don't care about who you are or what your trading position is. Trading is not for the faint of heart, there is a lot of pain, and one should be able to build the ability to take the pain, and soldier on. Moreover, you've to be more concerned about the positions you're in than the moves you're not in.
- Trading is all about going against the standard human emotions. As a trader, you're continually going up against your emotional limitations. That is why so few people succeed in trading. You have to have a high degree of self-awareness; you've to be able to see your flaws and your strengths and deal effectively with both - leveraging your strengths and guarding against your weaknesses.
- Our emotions should be used as a source of signals, and not as a hindrance to our trading process. In other words, treat your emotions as your friends, not your enemies. We should be aware of our emotional extremes and then trade accordingly. So, the moment you're feeling greedy, you know it's the wrong trade you're going to put on and the opposite for when you're fearful.
- The key to trading is emotional discipline. Making money has nothing to do with intelligence. In trading, the person who can easily admit to being wrong is the one who walks away as a winner. Besides trading, there is probably no other profession where you have to admit when you're wrong. In trading, you can't hide your failures. The trader who tries to blame his losses on external events will never learn from his mistakes. For a trader, rationalisation of one's mistakes is a guaranteed road to ultimate failure.
- Complacency has to be guarded against, particularly after a winning trade. After a successful trade, take a day off since successful trading is difficult to sustain. The rationale behind taking a day off after a winning trade is simple - winning streaks lead to complacency and complacency leads to sloppy trading.
- The common denominator among all the top traders is that winning has more to do with attitude than approach. Trading should be as unemotional as possible. The best traders have no ego. You cannot let your ego get in the way of a trade. When you're losing, you have to swallow your pride and get out - when in doubt get out. Always remember that the point is to make money, not to prove that you're right. If you keep doing the math and keep saying that you're right and the market is wrong, you're missing the point.
- In the stock market, 'It's not the best hand that wins, it's the best player.' And secondly, we should stop focusing on the outcomes and concentrate on the process instead. Trying to understand markets is a bit futile. A lot of people would rather understand the market than make money. That is another way of saying - are you trying to be right or are you trying to make money?
Booking losses and accepting our mistakes
- You have to be willing to make mistakes regularly; there is nothing wrong with that. The idea is to keep the losses from trading mistakes to a minimum. In a sense, one should learn to love small trading losses. When we are booking losses, the idea is to minimise the INR amount of the loss. This has got nothing to do with how much you can afford to lose. For every rupee lost, the loss of opportunity in terms of ‘dry powder’ gets reduced. Preserving optionality is what booking losses are all about. The larger the rupee value of the loss, the more harm it does to our mental attitude and trading size. The absolute amount of the loss should always be predetermined; this allows us to measure the risk that we are taking. Planning where you get out before putting on a trade is a means of enforcing emotional discipline.
- Don't get out of a losing trade too hastily. What he is saying is that often the worst time to bail out of a position is when there is violent price action against you. He says that if you can bear the pain for just a little longer, you will be able to lose less.
- Great money managers don't get attached to their ideas. If something isn't working out, they book a loss and move on. The implementation of your trade idea is very important. In other words, it's no use being a good forecaster, if the implementation is poor.
- The stock market behaves differently from all other markets and it also behaves differently from the stock market; which means that easily identifiable patterns seldom exactly repeat. The big crossover between the stock market and other games of chance like Poker is that in the stock market the rules of the game (the terrain) keep changing. Dealing with this variance is challenging.