The Four Pillars of the Stockscores Approach - Emotional Control
Stockscores.com Perspectives for the week ending January 13, 2008
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In this week's issue:
This is the final edition in the series, "The Four Pillars of the Stockscores Approach to Trading." Thus far, I have discussed when to enter, how to manage risk and when to exit. This week I look at the most difficult of the four pillars to master, "How to Manage Emotion". By far, it is this pillar that has the greatest influence on your success in the market.
I have personally taught thousands of people to trade the stock market. Through the StockSchool books, videos and live classes, aspiring traders have learned the rules of the Stockscores Approach for when to buy, when to sell and how to manage risk. Some of my students have become very successful, making a living trading the stock market. Others have failed to find success despite being taught the exact same things as the greatest money makers. Why can two people given the same information have very different results?
The answer is simple. We each apply the rules in our own way and many have a destructive response to their emotional attachment to money.
From an early age, we are all taught to fail in the stock market. To get through day to day life with a certain level of happiness, we must learn to avoid pain and pursue pleasure. These programmed tendencies hurt us as investors.
Losing money is part of trading, but losing unnecessarily as a result of our emotions is a destructive behavior that needs to be overcome. I think traders fail in their pursuit to beat the market for the many reasons including these:
Lack of focus
Failure to manage risk
Poor trading strategies
Inability to follow a good trading strategy
Unrealistic expectations
Lack of a viable plan
This is actually a list of symptoms, the true causes of investor failure are:
Fear
Greed
Laziness
Fear of losing money is the main reason we break our trading rules. No one likes losses and most investors are myopic; they judge their success in the market one trade at a time. The great traders know that success must be judged over a large number of trades since individual losses are part of the process.
Greed will be destructive to your trading success because it makes you focus on the wrong thing when trading. The profit or loss on the trade is irrelevant to the trading decision; we should buy because we have a trade that has a positive expected value and sell because the stock that we own is more likely to go lower than higher. Greed can make you buy too much of a stock or hold despite a contrary message from the market.
I believe that greed can be a powerful motivator but the desire to have easy money will lead most to financial destruction. Trading is not hard labor and it offers a great deal of freedom. However, if you think it is easy, you better quit now. Successful trading is simple, but not easy; it takes hard work to learn and discipline to consistently beat the market. It amazes me how many people are just not willing to put in the effort to be successful as a trader. The hard work necessary to learn is worth it because once you have developed a successful trading approach you can earn a lot of money trading. The highest paid people in the world (top traders in recent years have made over a billion dollars).
Overcoming emotion first requires a plan. You must develop and test any trading strategy for yourself, even if it is one that someone else has developed. You must make a plan with rules for entry, for exit and for the management of risk. You must prove to yourself that those rules will work and have an understanding of the potential for financial draw downs or even total loss.
The most profitable traders are the ones who are not thinking about the money. The best way to achieve this is to take no more financial risk than you are comfortable with. For some, that may be no financial risk in which case they should start with paper trading. With confidence, increase that risk to $50 a trade (remember that the risk per trade is the difference between your entry price and your stop price multiplied by the number of shares and then add in the commissions and potential for slippage). As you gain more confidence and establish a track record of success, increase the risk you take on each trade.
As you establish a trading history you create your most valuable learning tool. Your own trades can tell you a lot about your emotional make up and define the problems that will hurt you in the market. Don't waste that education by not tracking and reviewing your trades.
This review should do two things. First, you should see if the trading strategy that you tested actually works the way you found in your testing. Second, it should highlight the times you broke the trading rules. The latter analysis is what requires the most introspection because you need to figure out why you broke the rules. And then you need to make a plan to overcome those emotional breakdowns.
This series on the four pillars of the Stockscores Approach has discussed when to enter the trade, when to exit, how to manage risk and the emotional side of trading. The first three pillars are relatively simple, it is the emotional control where most people will fail and therefore it is the area where you must put in the most effort.
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For this final edition of the Four Pillars of the Stockscores Approach, let's discuss some of the emotional traps that may cause errors when trading AUXL, the stock I have focused on throughout this series.Back To Top
1. AUXL
The entry signal was on July 31 because of an abnormal breakout through resistance from a low volatility trading range. At the entry signal, a few common emotional traps come in to play. First, many rookie traders will simply hesitate and not take the trade. There can be a few reasons for this. First, the trader may lack confidence in the trading strategy. To overcome this problem, traders should do considerable testing so that they are convinced that the trading rules are successful.
Hesitation can also be caused by the negative memory from a recent loss that leaves the trader unable to take action. This is a pain avoidance mechanism; the recent trade is fresh in their mind and they get too focused on one trade rather than judge success over a large number of trades.
Another common mistake on entry is to not accurately consider the risk. Every trader should know and be comfortable with the risk of a trade. Position sizing should be based on the exposure to loss and what the portfolio and the trader's mental state can handle. Taking too much risk almost always causes an undisciplined break of rules later. The trader who is not comfortable with their exposure to loss will hold on to losers despite getting a signal from the market that they are wrong.
Immediately after I featured this stock it went in to a pretty good upward trend right away, gaining about 30% in 7 days. But on August 9th and 10th, the stock started to see some profit taking. This is where many traders make another mistake and sell too early. They tell themselves that they won't go broke making a profit and sell because they see weakness. They might get out with a 20% which seems very good for a 7 day hold period.
However, it is not a great trade because the profit does not adequately compensate them for the risk. This trade had a risk of about $2.50 and an exit on Aug 10th on the short term breakdown would give a profit of about $1.50 per share. For this strategy, given its anticipated success rate, the trader should be striving for a profit that is at least double the risk. That means a profit of less than $5 a share should be consider a failure.
The trader must realize that maximizing gains when you are right is essential to beating the stock market. As this stock wound its way higher, there would be many temptations to sell and lock in the profit. However, as it is even now, the stock has not given a sell signal (although it is very close to breaking its upward trend line right now).
Hopefully this example showcases some of the mistakes you have made in the past and teaches you the importance of not succumbing to your emotions. It is very easy to do so, but overcoming emotion is essential to long term trading success.
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References
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Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
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in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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