OVERTRADING

Overtrading is a symptom of a bigger problem; the one we have already discussed: GREED, BABY, GREED

Overtrading is typically defined as doing a lot of trades, mostly losers very quickly. Sometimes overtrading can be defined as trying to trade too many separate markets. Sometimes it is defined as jumping back into a market immediately after you have gotten out.  No matter how you want to slice it, making this mistake is very deadly to your equity.  Here’s why you need to guard against overtrading: THE TRADE IS A LOSER!! YOU OR THE SYSTEM OR BOTH ARE WRONG!! STOP TRADING FOR NOW!!!

By continuing to throw good money after bad you are no longer trading; you are gambling and/or hoping to get your money back.  You are not thinking clearly and you are probably ignoring reality.  It would be better to take a break and go do something else for a period of time.  When you are in a state of overtrading you are doing something that is completely psychological in nature and has nothing to do with the markets.  You see, the market does not know you have any position on at all.  The market is simply doing what it is designed to do, process orders from traders. The market has no idea what the results of those orders are for any one trader.  If you have lost touch with reality and can’t figure out which direction the market is more likely to continue moving in, it is very likely that you will be on the wrong side of the price action; you will likely lose more.  If you compound this problem by trading excessively your probability of success drops even farther.  It is better to take a break and just take your lumps.

As long as you have equity in your account tomorrow you can come back then and take a fresh look at it.  If you continue overtrading there is a strong probability you will lose a significant amount of your equity making it next to impossible to recover easily from a minor set-back.  Losses are part of the game.  They are a minor set-back.  If you complicate your losses by wildly flying in and out of the market hoping to get your money back you will lose your cool.  You will no longer see the market in an objective manner or let your system help you come back to even.

All trading approaches have their share of winners and losers.  If you compound your problems by doing trades your system never asked you to do, plus overtrading in the process, you are headed for a meltdown.  Overtrading is easy to spot and simple to stop.

First, if you are doing trades your system hasn’t called for you; you are overtrading.  If you are adding to a position (trading more) without a profit; you are overtrading.  If you are reversing after a loss (taking a loss then going the other way) and getting whipsawed; you are overtrading. If you are adding to a losing position with more contracts than when you first did the trade; you are overtrading.  If you are “winging it”; you are overtrading.  If you are trading too many markets and committing 100% of your equity all the time to all those markets; you are overtrading. In short, overtrading is any trading you do that is not part of your original plan and not part of your trading system.  Overtrading is any trading that causes you to risk more than a reasonable amount of your equity on any one trade.  If you spin yourself silly you will not have enough equity to recover.  Don’t be the trader who is overtrading.

HOW TO MAKE THIS MISTAKE WORSE: Ignore common sense with regards to how much trading you are doing, don’t count the number of trades you did daily, tell yourself it is OK to add to a loser “just this one time”, get angry with people who ask you how you are doing, ignore professional advice, trade without a stop-loss order.

SOLUTION: Set a number of losing trades in a row and stick to it. If you number is three losers in a row; then have the courage to quit after those three losers. Don’t go back in 4, 5, 6 or more times thinking “you will get it back”. Ask professionals to look at your trading history and follow the advice they give. If you have a certain number of losing days in a row, take a break for a few days.

VARYING THE SIZE OF YOUR TRADES

Most professional athletes can tell you when they are “in the zone”, that special place that only they know about but it leads to maximum performance.  Every one of those athletes will tell you that they got that way by strict discipline and practice.  One of the things that they practiced constantly was the basics as they understand them to be.  A golfer has “his swing”.  A baseball player knows “his pitch”.  A racing car driver has “his line”.  These professionals got there by following the bedrock basics all the time.

In trading, the bedrock basics include trading a size that works for you.  Just because you can trade a 50 lot of something doesn’t mean it is a good idea for you to do that.  It is a mistake to think that whatever trading size you choose to work with day-to-day will automatically “fit” in your head.  In fact, most traders will tell you the single most embarrassing blow-out they have had is the one that came from varying their trade size when doing well.  In other words, they were pulling money out of the markets regularly and decided to increase their trade size just because they could; and subsequently the resulting new levels of equity gains or losses threw off their equilibrium.  It made them see things differently and they lost enough of their edge to cause themselves losses.

To help put this in perspective, look back to a time in your life when you were trying something new for the first time.  Did you ever have the feeling that someone else “made it look so easy”?  Imagine your son or daughter being exposed to baseball or ballet for the first time.  You and the instructor can plainly see that those kids have what it takes to excel at these sports.  But if you push them too fast they will get discouraged because they “can’t do it”.  Of course they can do it, but they don’t see that yet and they lack the confidence that doing the basics well can offer them.

Imagine a 10 year old Hank Aaron with no experience staring down Major League Pitcher Al Downing for the first time.

In my early life, before I was a trader, I had the privilege of learning how to drive an open-wheel single-seater race car.  The education process started with a lot of classroom theory followed by getting in the car and just doing it.  I had to start at small “revs” so the car didn’t get ahead of me; in other words drive slow at first.  After every few laps we had some critique by the instructor.  While I was learning I was never allowed to exceed a certain amount of revs.  Some guys in my class were never given the go ahead for higher revs; they flunked out.  When my turn came I was given the green light to “see what the car could do”.

Because I had gotten really good at doing the basics of cornering I had absolute confidence and respect for my developing talent.  I came within a few seconds of a course record on my third round of “full lapping” at full revs.  I had no idea I had done that well; I just felt “in the zone”.

When my instructor offered me a chance to move up to a bigger horsepower car I had absolutely no worries.  20 minutes later I was so scared I thought I would kill myself.  I was making serious mistakes, my speed was dropping and I was “off my line”.  In retrospect, and my instructor told me this, he had moved me up too fast. Although I was getting good at lapping with a lower performing car, I didn’t have the real bedrock knowledge yet.  I needed more time and experience.  When I got that time and experience I was a real driver—but that took two more years.

I honestly believe that if I would have stayed with the bigger car initially I would have had a huge accident and maybe gotten seriously hurt. Trading is a lot like that learning curve.  What makes you a success at an early stage is not necessarily going to be what keeps you successful as the game goes on.  As you get better and better it is tempting to increase your trade size.  When you do, it is not uncommon for the new set of parameters and risk/reward numbers to “mess with your head” so much it leads to losses.  Things were going really well but now you are losing ground.

Don’t be the trader that thinks he can do it all, all the time. Don’t vary your trade size easily.  Stick with what you know is working and plan on increasing your trade size for very good reasons and at a certain level of success.  Don’t do it too fast or you will find yourself holding losses for no real reason you can figure out easily.

HOW TO MAKE THIS MISTAKE WORSE: Focus on the money being made instead of the discipline required to get there, make your trade size as big as possible for your account size, ignore money management rules, don’t run a stop-loss order, trade larger when losing.

SOLUTION: Make the commitment to trade only a certain size until you have successfully doubled your account balance. Don’t increase size until you have done at least 100 trades with your system. No matter how well you are doing don’t increase your size for a full calendar year.

TRADING TOO LARGE FOR YOUR ACCOUNT

The fastest way to go broke is to bet it all, all the time.  Most traders don’t learn this lesson until they have had at least one blow-out; by that I mean they have lost all their equity quickly and have had to start over.  For some reason, there is a tendency for traders of all age and experience levels to trade too large for the actual cash in their account.  This is a symptom of a larger problem and unless you are willing to consider that you personally might have this problem already you most likely will be trading too large for your account right now today.

What is this larger problem?

GREED, BABY, GREED

It is unrealistic for you to believe you are going to make a killing on THIS ONE TRADE RIGHT NOW.  Sure, you might be on the right side of a large move but that will take time and evidence to see.  For this moment, any trade you have on has the potential to run the other way against you and if you are trading too large, your potential to lose a lot on only a few trades is huge.  No matter your age, education, skill or experience level you are not going to make 100% winning trades.  Therefore a certain percentage of your trades will simply not work.  Those trades cannot be so large that you lose a significant portion of your equity in the process.  To beat the greed habit you need to make a few changes to both your equity management and more importantly to your thinking.

First, trading is a business. You need to treat it like one.  There are certain things every business needs to run effectively and the first thing is liquidity.  Simply put, if you run out of cash to play you can’t remain open.

Second, if you had a reasonable plan in place already then it is a good guess that your plan calls for only a reasonable amount of percent gain on your equity regularly. If you were to use some basic mathematics while creating a sound trading approach one of the things you would be looking for was a realistic “risk-to-reward” ratio.  That means for every dollar you lose you expect to make a certain number of dollars and out of every 100 trades a certain percent will be winners and some will be losers. If you put this all together and asked the “what-if?” questions you get this base-line number that statistically will be a winning set of results: 42% winning trades out of 100 taken Two dollars out for every dollar you give back This is not my opinion, this is the Probability of Ruin Matrix and you can research it yourself if you have time.  Of course, if you have higher percentages of winners and take more out on those winners you make money a lot faster but the point is if your results are at least this good consistently you are on your way to success.

It’s great to be on the high side of the matrix but most of us didn’t start there and that is why you have to TRADE SMALL at first.  To protect yourself from being greedy about your trading and to help you stay focused on long-term success it is important to make your trade size small enough so that it won’t leave you in a position of not being able to play at all should you have a string of losses all at once.  I found that limiting your risk/reward ratio to a factor of about 1.5% on any one trade is a great way to stay focused and not get greedy.  This means that for any one trade you take, no matter how you think of the trade or how certain you are of a win; you will not risk more than 1.5% of your account balance at any one time.  This means that if you are trading so that your average loss is 3-5% of your account balance at any one time, you are trading TWO to THREE TIMES TOO LARGE for your account size.  In that case, the Probability of Ruin Matrix will work against you and you will likely run out of capital before you make money with your approach.  If you are the greedy trader right now and you are guilty of making this mistake; If this means you have to drop your trading size down a few notches then you had better call your broker today and fix it, because if you don’t you are an accident waiting to happen. It only takes making this mistake THREE TIMES IN A ROW to drop your account balance 15% or more in a heartbeat; especially if you are day trading!

HOW TO MAKE THIS MISTAKE WORSE: Convince yourself you are so good at trading that this couldn’t possibly happen to you, convince yourself that your analysis is good enough to help you find 80-90% winning trades all the time, trade without a stop-loss order “just this once”, double-up on the next trade after taking a large loss.

SOLUTION: Immediately reduce your account balance; take 20-30% of your cash home. Trade position sizes that are no more than 300% as valuable as your account balance. In other words, if your account size is $10,000, don’t trade anything that has a total contract value larger than around $30,000. If that means trading mini’s instead of big-board you had better do it.

NOT HAVING A TRADING PLAN

Suppose you called your 401K manager this afternoon.  Suppose you asked him “What is your plan for the next six months?”  Suppose he told you “Oh, whatever. I just try to get on the right side and if I don’t I just get out”.  How long would that guy be managing your retirement money if you had any say in the matter?

Many traders take the same attitude with their daily work habit and many don’t even know they do it.  Not having a clear and concise plan for your daily trading presence is a serious mistake and you need to address it.  The best way to describe a sound plan is to let you read one from a professional full-time trader.

This is an actual trade plan from a friend of mine who is an E-mini trader:

2006 Trading Plan My goal is to earn 100% on my trading equity before the end of the year. To maintain my focus I will set a near term goal every quarter to be at a 25% gain and I will plot my equity daily.  If I reach my quarterly goal ahead of the last trading day of the quarter I will take a two-day break. I will hold any open positions that are at a profit but any open trade losses I will close at that point before I take a break. If my open trade gains continue into the new quarter I will add to those winning positions by a factor of 25%.  I will move my protective stops up to reduce my exposure on the entire position.  If I am behind on my trade goal for the quarter, I will take a five-day break.  I will re-evaluate my trade system and ask the question: “Has my market quality changed to something my system is not able to perform at best?” During the year I will not trade more than three markets.  I have learned I cannot focus well on more than three markets at a time. If I have more than four losing trades in a row in any of my three markets I will take a trading break for five days. Again, I will leave open position winners alone in the other markets but close all losing positions. I will again roll protective stops to reduce my risk.  When I take a trading break, I will enter resting limit orders in the open trade winners to take the objective profit should I be unavailable and the market gets to those levels during my break.

If I am ahead of my plan for the year at any point I will take a break.  I will take 30% of the new equity out of my account and place that into a secure place.  If I am behind I will not add equity under any circumstances.  If I reach a 40% drawdown from my high equity I will quit for the year.  I will record my daily trade activity in my trading log and review this weekly.  I will know my ratios and results; I will look to improve them by 5% each week.  I will trade only from the bull side because my analysis tells me that all three of the markets I have selected have more than a year of solid bullish fundamentals.  I will learn how to use options this year because I see from last year I could have protected more trades if I had a solid grasp of when to use options and when not to.  I will invest two-hours a week on option knowledge. My son is leaving for Europe in May.  I will not trade the week before he leaves or the week after.  I plan to join him in the fall for Oktoberfest for one week and will not trade the three days before I leave or when I get back.  I know I suffer from jet-lag so the week after I am back I am not at my best. I have blocked out these times on my trade calendar so I will not be tempted to trade anyway.

If you read between the lines you will notice that his trade plan included all the things that were in his control, NOT things outside of his control; like the markets.

HOW TO MAKE THIS MISTAKE WORSE: Base your trading plan on hypothetical profits or on how well you did paper-trading, Ignore your personal emotional needs when compiling a plan, Ignore your family while making a plan, keep thinking you can trade everyday or all the time, average your potential over a period of time and think results will equal a daily amount.

SOLUTION: Ask a professional trader to show you his daily/weekly/monthly or annual trading plan.  Ask yourself if you can make a plan that addresses similar things.  If the professional you have selected can’t show you or won’t show you his plan then ignore what he has to say.

If he isn’t using a plan then he is likely unable to assist you in building wealth.

Seriously you still don’t have a plan…GET IT DONE NOW!

PAPER TRADING TOO LONG (Virtual Trading)

Paper trading is hypothetical trading. If you have never traded anything before, you will probably do some paper trading. The benefit of paper trading is that it will help the new trader become acquainted with the basics of interfacing with the markets. This is often a “demo” account with a broker or clearing firm that provides real-time market data but provides a hypothetical balance. You are allowed to buy and sell as much as you want, just like in a “live” or “real” account. Your hypothetical gains and losses are accrued against your hypothetical account balance over time. As time goes on, most traders find that they can gain quite a surprising amount of paper-profits in a very short period of time. These traders are now completely convinced that they can easily duplicate those hypothetical results in real time with real money. They open their real trading account and POW! Within about three to four weeks they are down usually more than 50% of their equity. This is not my opinion, this is actual fact. Ask any broker in the industry what happens to “paper-traders” who open a real account. The ratio of “paper-traders” to “winning traders” is about one in ninety.

Why does this happen? Because there was never any real risk to the trader.

Let me illustrate by telling you a story:

I know a private pilot who soloed on his 17th birthday.  In 1979 he was an Air Force academy appointee. He has flown a T-38 Jet fighter in extreme conditions.  Just knowing that, I think most people would agree that he probably has a certain amount of experience flying airplanes.

In the suburbs outside of Chicago there is a small airport that has a “Fighter Pilot for a Day” program. This is where you fly co-pilot with a retired military pilot in high-performance aircraft. You are allowed to fly the aircraft (with the real pilot’s hands on the controls) in an attempt to “shoot down” an “enemy” fighter; which is another co-pilot flying another airplane with HIS retired military pilot.

You are awarded a “kill” if your laser guns hit your opponent.  It’s like a very expensive high-stakes game of laser-tag. He went for a day to have some fun.  As it turned out, he was flying against a complete novice.  Of course, he didn’t tell him that he had some Air Force training.  He asked his adversary what kind of training he had.  He very confidently told him that he was the top scoring “ace” from his on-line club and various other national methods of playing of high-tech video games.  He also told him that he could “out-fly” almost anyone in the Microsoft Flight Simulator in both the F-16 Falcon and F-15 Eagle.

Everyone agreed that his credentials were very impressive and proceeded to blow him out of the sky no less than six times in 20 minutes.  To start with, this novice had never flown in aerobatic conditions so he spent most of his time trying not to throw-up.  He stalled and spun most of the other time.  If he wasn’t flying with someone he’d be dead. In the end he had to quit early because he simply couldn’t take the physical punishment.  To add insult to injury, my friend has never played Microsoft Flight Simulator (ever).  He does the real thing.  There is a BIG DIFFERENCE between the two as you can see.

Do you see the point I’m getting at?

PRETENDING to do something is never the same as actually doing it.  Yes, it is helpful up to a certain point to simulate certain things but that can only take you so far.  In the case of air-to-air combat, PRETENDING to be a fighter pilot will likely get you killed if you ACTUALLY go up against a trained fighter pilot.  In fact, the US Army Air Corps learned this the hard way back in WWI.  They sent young men into combat with oftentimes less than 10 hours of actual flying time.  Imagine how fast those men were killed when they went man-to-man with Richthofen, Boelke and Immelmann.

Everyone concluded flying was “dangerous” when in fact it was the lack of training that was “dangerous” I’m not trying to impress you with my friends flying skills.  I’m trying to impress on you that paper-trading is exactly like playing Microsoft Flight Simulator.  It is pretending to be something you are not while convincing you that you know what you are doing.

Paper trading hides from you the need for real skills. Paper-trading will get you killed because when you go up against real traders with real money it’s not a game anymore. If you make the wrong move you lose equity.  There is no “do over” button. If you stall your F-16 in the simulator, you get another chance; stall your F-16 in combat and you die.  Lose money in your paper-trading account; just sign up for another trial account.  Lose money in your real account and you go home broke.

Paper-trading is a waste of time because paper-trading will never give you the real skills you need to trade.  All paper-trading can do is help you learn how to use the functions of your trading platform.  In fact, that is a good thing.  But once you learn the functions of your platform and your account is ready to trade, everything you learned paper-trading goes out the window because NOW IT IS DO OR DIE.  There are no second chances.  Don’t make mistake #1; don’t think you know what you are doing because you pretended to trade without taking any real risk.

HOW TO MAKE THIS MISTAKE WORSE: Continue paper-trading for more than 30 days and/or go back to paper-trading if you have lost money in your first real account.

SOLUTION: Open the absolute smallest account your broker will allow and trade for 90 days the absolute smallest size possible.

If you are ahead, increase your equity size and your trade size by a factor of 20%.

If you are losing, stay with the real thing; it’s the only way to learn.