Fri, Oct 12, 2012
Evolution of a Trader
As traders develop skills, each one travels virtually the same path: initially as a discretionary trader, then as a technician and ultimately as a strategist or systematic trader. A trader first analyzes the market direction or trend, then sets targets for the anticipated move. Correctly reading or predicting the marke t then becomes the highest priority, so the trader learns as many new indicators as possible, believing they're like traffic signals. This search for a magical combination of indicators leads to the inevitable realization that multiple scenarios might exist. A trader's focus then moves to the probability of each outcome and the risk-reward ratio.
The discretionary trader uses nonquantifiable data - such as advice from a broker or perceived expert, news reports, personal preferences, observations and intuition - to determine entry and exit points. Position sizes and leverage are flexible. Although such flexibility can have its advantages, more often that not it proves to be the trader's downfall. Discretionary traders often find inactivity the hardest part of trading; as a result, they're prepared to embrace any development that will allow another trade. This impulsive behavior, in fact, isn't trading at all - it's gambling, similar to that described earlier. And just like in the casino, the odds are not in the overtrader's favor.
Hair-trigger trading is enhanced by electronic trading, which makes it possible to open or close a position within seconds of the idea forming in the trader's mind. If a trade moves slightly against the trader, it is sold immediately; if a market pundit shouts out a tip, a position can be opened before the ad break. Hair-trigger trading is easy to identify. Does the trader have many small losses and a few wins? Looking back over trade logs, did the trader overestimate his wins and conveniently dismiss his losses? Were trades exited almost as soon as they were entered? Are some positions continuously opened and closed? These are all classic, easily-identifiable signs of hair-trigger trading.
Craving the action, traders often develop a "shotgun blast" approach, buying anything and everything they think might be good. They might justify this by the fact that diversification lowers risk. But this logic is flawed. First, true diversity is spread over multiple asset classes. Second, multiple bad trades will never be better than just a few. If a trader has isolated a promising trade, concentrating capital on that trade makes the most sense. A telltale sign of shotgun trading is multiple small positions open concurrently. But an even more firm diagnosis can be made by reviewing trade history and then asking why that particular trade was made at the time. A shotgun trader will struggle to provide a specific answer to that question.
Bandwagon trading is a deliberate attempt by discretionary traders to piggyback or mimic those they consider to be "in the know." This ploy is fundamentally flawed for two reasons. First, even experts don't have all the answers, and they can't predict the future. Their experience and talents are merely two factors among many.
The second reason is that when many traders follow the same path - led by a loudmouthed pundit, a biased stakeholder or the results of many technicians inadvertently using the same indicators - the initial move may degenerate rapidly. This is a basic economic principle: competition reduces margins. In trading, this manifests itself when bandwagon traders compete to exit identical positions as early as possible, often causing a price stall or reversal.
Movers and Shakers
The market is not always smooth sailing. Instead of large trending moves, it sometimes shakes about in a choppy, sideways direction. Many novice traders will overtrade by assuming that minor market corrections are the beginning of the next trend. They'll then jump in and out as the expected trend forms and fails. They may even compound the situation by doubling their positions.
The various forms of overtrading can be explained by the amateur's order of priorities. First and foremost, the beginner trader wants to confirm the advisability of his trade by taking profit whenever possible. Secondly, the novice trader wants to reduce his emotional discomfort either by selling as soon as a loss appears or by immediately re-entering the market after a loss or period of inactivity, hoping to "win it back" just like the casino gambler. Overtrading makes only a broker happy; the true professional's priorities will look like this:
- Avoid losses
- Minimize risk
- Minimize volatility
- Maximize returns
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