Five Uncommon Rules of Wealthy Traders
Over the past year, I’ve spoken to hundreds of traders, many of whom were recorded and posted here on MoneyShow.com. If you had asked me a few years ago how the best traders approached the markets, I would have said that they all had similar strategies. But after talking with traders of every market imaginable, I’ve found they all have very different methods.
However, while they each may use wildly different techniques (I spoke with one very wealthy trader who confirmed his chart patterns by looking at planetary movement and moon phases), all of them follow five rules without exception. Some of them make hundreds of thousands—even millions—of dollars each trading their own accounts. These aren’t your typical “Always use a hard stop loss” type of rules. These are more philosophical guidelines that successful traders follow without exception.
In fact, I’d bet that deep down, you know you should be following these rules as well, but you aren’t…yet. Today is the day you can commit to doing what works for other wealthy traders and get on that same path.
Let’s get started.
1) They Plan Every Single Trade—Every Single One
Every trader I’ve talked with who makes money consistently knows the following about every single trade they take before they even begin entering a limit order into their trading platform:
a) The highest price they are willing to pay (if they are going long) or the lowest price at which they are willing to sell (if they are going short)
b) Their profit target where they will exit if they are “right”
c) Their stop loss where they will exit if they are “wrong”
d) The risk/reward ratio of the trade
e) The exact percentage of their account they are risking
Lots of traders do one or two of these things. Few do all of them. In simple terms, they know exactly what they want to pay, how much money they anticipate making (or losing), and have a very clear idea on the probability of the trade working out.
Although you might think that every great trader uses hard stops that are pre-programmed in, many don’t. However, they are highly disciplined, and when their stop loss number comes up, they are out. Most traders don’t have that type of hardcore discipline and so a hard stop loss is still their best option.
2. They Stopped Trying to Pick Tops and Bottoms Years Ago
Nearly all of the classes, courses, and Webinars you’ll find on the Internet talk about using support and resistance of some type to find where a market is turning and how to get in before or while it does.
The funny thing is that only a very few successful traders I have ever talked to trade that way. Simply put, 95% of the traders out there who make money are buying higher highs and selling lower lows. They do the exact opposite of nearly everyone out there because they found out long ago that picking tops and bottoms is a sucker’s bet. One trader described it to me by saying that it’s much easier to just participate in what a market is already doing than trying to guess when that behavior will change. Flip flop your strategy to agree with what the market is doing, rather than guessing on when it will change its mind, and you’ll be in a much better position to make money trading.
3) They Are Patient with Winners…and Ridiculously Impatient with Losers
Dennis Gartman is famous for boiling down great trading to one thing: “Do more of what is working and less of what isn’t.” Sure makes a lot of sense to me.
Most traders have a great deal of patience with their losers but get nervous about locking in gains and sell them too quickly—the exact opposite of what wealthy traders do. Wealthy traders realize that they may actually have more losing trades than winning trades, so they quickly get out when they are wrong. It is the only way to ensure that they can give their winners the attention they deserve.
They coddle their winners and kick their losers to the curb without a second thought.
4. They Trade One Market—Just One
This one is a bit controversial. I’ve talked with great traders who can trade futures, forex, and stocks at the same time. They are a gifted tiny minority.
The vast majority of successful traders concentrates on one market and become so comfortable with it that they begin to “know” the behavior of that market just watching price and volume. Test yourself—if you aren’t able to get rid of all your charts and simply look at price and volume to trade, you’re probably not concentrating enough on one market in order to know its moods. What we’re really talking about here, of course, is not the mood of the market itself, but the moods of the market’s participants!
Focus on trading one market exceptionally well rather than trying to trade whatever’s hot—that’s how wealthy traders do it.
5. Their Benchmark for Success Is Anything But Money
Money changes everything. It sure does. We’re all in this to make money. The trouble is, when traders use the amount of money they make to judge their own success, something happens to them—to all of us, really—that clouds our decision-making abilities.
Wealthy traders have realized this and instead focus on other things to determine if they’ve had a successful day. Whether it be how well they were able to execute on their trading plan (see rule #1), or their overall ability to predict short-term movements in whatever they are trading, they know that if they do those things correctly, the money will follow.
Yes, of course the money is important. Any trader who says otherwise is a fool. Why else would we put ourselves through this daily ride? But there is something about making it a secondary focus that allows the best traders to make better decisions. The growing trading account simply becomes a nice result—a side benefit, if you will—of making good decisions and reading the market well.
By Tim Bourquin, co-founder, The Traders Expo and TraderInterviews.com
Throughout my financial career, I have continually witnessed examples of other people that I have known being ruined by a failure to respect risk. If you don’t take a hard look at risk, it will take you.
Frankly, I don’t see markets; I see risks, rewards, and money.
My philosophy is that all stocks are bad. There are no good stocks unless they go up in price. If they go down instead, you have to cut your losses fast… Letting losses run is the most serious mistake made by most investors.
[Michael Marcus – another top trader] taught me one other thing that is absolutely critical: You have to be willing to make mistakes regularly; there is nothing wrong with it. Michael taught me about making your best judgement, being wrong, making your next best judgement, being wrong, making your third best judgement, and then doubling your money.
That cotton trade was almost the deal breaker for me. It was at that point that I said, ‘Mr. Stupid, why risk everything on one trade? Why not make your life a pursuit of happiness rather than pain?’
Paul Tudor Jones
If I have positions going against me, I get right out; if they are going for me, I keep them… Risk control is the most important thing in trading. If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in.
Paul Tudor Jones
Don’t focus on making money; focus on protecting what you have.
Paul Tudor Jones
The elements of good trading are: (1) cutting losses, (2) cutting losses, and (3) cutting losses. If you can follow these three rules, you may have a chance.
When I get hurt in the market, I get the hell out. It doesn’t matter at all where the market is trading. I just get out, because I believe that once you’re hurt in the market, your decisions are going to be far less objective than they are when you’re doing well… If you stick around when the market is severely against you, sooner or later they are going to carry you out.
I’ll keep reducing my trading size as long as I’m losing… My money management techniques are extremely conservative. I never risk anything approaching the total amount of money in my account, let alone my total funds.
When I became a winner, I said, ‘I figured it out, but if I’m wrong, I’m getting the hell out, because I want to save my money and go on to the next trade.’
Learn to take losses. The most important thing in making money is not letting your losses get out of hand.
I always define my risk, and I don’t have to worry about it.
The key to trading success is emotional discipline. If intelligence were the key, there would be a lot more people making money trading… I know this will sound like a cliche, but the single most important reason that people lose money in the financial markets is that they don’t cut their losses short.
I think investment psychology is by far the more important element, followed by risk control, with the least important consideration being the question of where you buy and sell.
The Power of Now
Debra looked at the candle on the daily chart. It was yesterday’s candle and it was red just like several before it; and it looked good. You see, it represented a pull-back from a high several days ago on the YM E-mini. The high was the latest in several higher highs and higher lows that stretched back a few months representing a strong upward trend. What looked attractive to her was the fact that the price action had bounced off a 10-period and a 15-period exponential moving average several times, and as well the highs pulled back off significant resistance levels several times. On this day, the price action’s pull-back was hitting a significant support level, which also happened to be coinciding with an upward cross-over of the two moving averages at the open. For her, this was an important set-up that she had been waiting for.
Debra was an experienced trader, and she appreciated that having a trade plan was essential; she also had a plan for this trade as well…that was her method; she aimed to plan her trade and trade her plan. There was, however, a fly in the ointment…she “knew” that the price action was going up! In this instance, she had a “long” internal bias fuelled by certainty…this is not a good thing.
As she executed her limit buy order slightly above the resistance-that-had-now-become-support level by a tick, her order automatically set her hard stop four points below the entry when she was filled. Everything looked superior, that is until the price action began to breathe, dropping down one point, then two, then three and got perilously close to her stop.
However, Debra “knew” that the price action was heading up. She told herself that the set-up was perfect, and she wasn’t about to let a dip in the price hit her stop, take her out and then retrace upward leaving her behind. So, she moved her stop. This was a clear violation of her rules, but she felt a little fudge was OK; after all, she was about to profit nicely when the price action finally goes up and hits her target for a gorgeous 4:1 reward. But, to her dismay, the price action continued to drop and headed straight for her stop again…and she moved her stop again. She was now fully caught up in her certainty, blinded by fear of taking a small loss, fear of being wrong and greed as she anticipated the profit.
Then she thought, “…oh what the heck, it’s going to go up; look at that trend.” So, she took her stop out. Just then something terrible happened; something that she had never in her wildest dreams of this trade had anticipated…the price action began to plummet like a red brick falling off a high ledge. You see, this was February 27th, 2007, when the Dow dropped 350 points in 5 minutes, and a 500 drop total for the day. She watched in horror as the long red candle bled down her chart and haemorrhaged her account. But, she was unrepentant because she still held on to the “hope” that the price would come back.
As the price approached the Average True Range she thought, “…well, it surely will retrace at the ATR, and even if it doesn’t come all the way back, if I double down, I will get my money back!” But, alas, it didn’t come back and the price continued to fall. She was frantic and fully frazzled by the events that were unfolding in front of her. When the pain became so acute that it wrestled her from the trance she was in, she finally liquidated her position; but not before she had lost 20% of her portfolio in one trade and in one day! Now, this story begs the questions: Was this catastrophic loss due to a lack of knowledge? No, it wasn’t; Debra had experience and knew what she was doing. Was the loss due to something that couldn’t be managed? No, with training and the use of emotional tools, she could have managed her situation and taken the small loss early on. And, lastly, if she had followed her rules, could she have avoided this disaster? Yes, most definitely. Debra had found herself in a negative trader trance stimulated by fear and greed, and driven by subconscious beliefs and thoughts.
Episodes such as Debra’s can and do happen all too often for far too many. In fact, for some it is a daily occurrence. The point is to remain in a state of self-awareness and to be in the moment for the moment, fully available, fully present and in the now of the trade. In this way you will be able to align yourself physically, mentally and emotionally so that your entire system is working in the same direction and on the same goals.
When you are aligned you can access and activate internal resources like the ability to remain focused with intention and attention on what matters most; and the ability to see both the big picture and the details with emotional tools at your disposal in the service of your “A” Game. When you do this, you can resonate with the reality of the charts and the markets without succumbing to internal bias. You can develop a “positive trader trance” in order to be proactive in trading what you see, and you’ll be less prone to being seduced by illusions brought on by what you’re making up about the market, the news or the charts.
Now, being fully available, in the moment for the moment, fully present and in the now takes practice. The tendency for most people is to focus on the past or the future in a negatively obsessive rumination about past injustices and losses; or future angst ridden doom and gloom visions of how things will turn out badly.
Your mind is always turned on and you must break the spell of the ego which makes you a slave of your rampant, unceasing, monkey-mind that is full of underlying subconscious limiting beliefs, negative thoughts, and painful emotions. Breaking the spell of the ego means, in part, that you must identify the gaps between the thoughts where you can return to just being and without judgment notice and become aware.
The practice is necessary because it’s quite difficult to wrestle yourself free of the barrage of thoughts and to allow yourself to focus on exactly what you are doing in “this” moment only; to find joy in being on purpose and on task with even the most seemingly mundane chores. Make a game of it and you’ll find that it becomes easier and easier to focus in the moment and bring yourself closer to a “flow” experience.
The flow experience was coined by psychologist Mihaly Csikszentmihalyi in his book “Flow: The Psychology of Optimal Experience.” In it he outlines his theory that people are most happy when they are in a state of flow or concentration, complete absorption with the activity and situation at hand. Flow is identical to the feeling of being in the zone. It is being completely involved in an activity for its own sake; the ego falls away and time flies. Your whole being is involved and you’re using your skills to the utmost.
There are several tools that can help with being in the now and in the flow state and many of these are taught in Mastering the Mental Game. Tools like Emotional Freedom Technique, Meditation and Self-hypnosis that can support a positive trader trance where you’re apt to develop a magnificent obsession with doing only what is in the best interest of your “A” Game and highest and best trader.
Dr Woody Johnson can be contacted at The Online Trading Academy
Behavioural Economics for Traders
By Khurrum Naik
If you buy a stock for $50 and it reaches an all time high of $100, but you sell at $75, why do you feel that you’ve made a loss?
Minds and Markets
In most people’s minds finance and economics are the domains of clear, quantitative thinking. Economists merely uncover financial truth one after another as they develop new mathematical tools for modeling capital and how wealth is created. Markets, likewise, are ethereal natural forces tapped into rather than created. In truth, the assumptions that underly the pricing models used for the past three decades are based on two basic principles:
People make rational decisions
People are unbiased towards new information
Meanwhile, down the hall on university campuses, researchers in cognitive science have uncovered evidence that humans are not quite the rational decision makers expected. Humans make decisions with limited information and rather than treat new information with independent probabilities, context and history are critical to our decision making.
Humans often make predictable cognitive errors. As George Soros states in his classic “The Alchemy of Finance”, it was when he moved from stock analyst to fund manager that he found that what he thought and how he made decisions suddenly became of paramount importance, as his fund depended on his sound decision making in arenas not limited to picking stocks.
These biases affect novices and expert traders alike. The value of a particular financial instrument depends heavily on the perception of its value. How is value determined? Again, we feel this is simply a matter of relying on objective mathematics. Numbers are not enough to describe investor decision making.
Take a simple coin toss. Ellen Langer showed that people are more willing to bet on the outcome before the coin is flipped than after. People behave as if their involvement makes a difference in value. You’re thinking, “How foolish, I’d never make that mistake”. If you’re like most college students, you think you are above average. As a matter of fact, 82% of them do, according to a classic study by Ola Svenson. Overconfidence is a consistent bias humans show, and it shows up in the markets.
Overconfident traders trade too much. Overconfident traders believe their information and ability to act on it is superior to most and they will profit from their actions. This leads to excessive trading, which hurts profitability. Overconfidence also leads to higher risk taking. As John Nofsinger points out, this is partially due to the illusion of knowledge, the notion that more information improves decision making.
If I ask you what the odds of a dice rolling a 4 are, you would likely conclude 1 in 6. If I then tell you the die previously rolled a 4 six times in a row, you might be assign a greater likelihood on the dice rolling a 4, or the contrarians might say less. Although the dice has no memory, people do, and it affects their decision making. As we saw in Langer’s research, the very act of participation changes one’s sense of value. Thus the novice trader’s new tools and research may act to instill excessive confidence in the decision making process.
In considering the past, investors often rely on what Novel Prize winner Richard Thaler dubs “mental accounting”. Sums of money are categorized as “losses” or gains” and then treated differently, counter to what the rational model of economics would predict. One experiment that demonstrates this by Hal Arkes and Catherine Blumer showing how the labels we assign costs affect our decision making. They asked subjects to consider this scenario:
“A family has tickets to a basketball game, which they have been anticipating for some time. The tickets are worth $40. On the day of the game there is a big snowstorm. Although they can still go to the game, the snowstorm will cause a hassle that reduces the pleasure of watching the game. Is the family more likely to go to the game if they purchased the ticket for $40 or if the tickets were given to them for free?”
The typical response was that the family was more likely to attend if they purchased the tickets. The cost is the same in either scenario. But the decision to attend affects the outcome people choose. By purchasing the ticket, the mental account of a cost for attending the show is created. To “close this with a loss” is aversive, and people believe that the goal must be attained by purchasing another ticket.
Not only was the basis of the decision factored, but it was shown that timing mattered as well:
“A family has long anticipated going to the basketball game, which will take place next week. On the day of the game there is a snowstorm. Is the family more likely to go to the game if they purchased the $40 tickets 1 year ago or yesterday?”
In this scenario, subjects thought the family would be more likely to attend if they just purchased the tickets. Although the time value of the money spent would be greater from a purchase a year ago, the psychological cost has diminished over time, and people are less likely to be hurt by the cost.
Mental accounting also accounts for the risk behavior traders exhibit. Richard Thaler also showed that people are more likely to accept a wager on a coin toss if they had just been rewarded money than if they had not. This “windfall” profit is classified as a bonus, and thus risk capital. The percentage of economics students willing to accept a bet of $4.50 in a coin toss went from 41% when they were not given any money to 77% when they were given $15.
Thaler also showed that experiencing a small loss produces risk aversion to a fair bet, but if they lost significant money and offered the chance to “break even” a majority of students accepted, even if the bet was not fair. Losses can exacerbate losses.
One common phenomenon many traders know all to well is selling winning trading and holding losing trades. Hersh Shefrin attributes these to the desire for pride and avoidance of loss. If you record a trade with a profit and a trade with a loss, you may realize the profit to attribute a successful trade to your sound decision making, but avoid realizing a loss that speaks otherwise. Although this seems simple, capital gains tax incentivizes holding winners to avoid realizing capital gains and selling losers to reduce taxes owed – the opposite strategy that most traders pursue.
Terrence Odean examined 10,000 trading accounts from 1987 to 1993 from a national discount brokerage to see the percentage of winners and losers closed in proportion to the number of paper winners and losers held. He found sales represented 23% of the number of total gains and losers represented about 16% of total losses. In other words, investors are twice as likely to close winners than losers.
Anchoring and Adjustment
What counts as a gain or a loss is also relative to prior prices, not considered as independent of an investor’s attention. A stock acquired at $50 and and achieves a year-end value of $100. A few months into the new year it is sold at $75. While this is objectively a $25 gain, the investor likely feels as if there was a loss. One classic decision-making bias Nobel Laureate Daniel Kahneman and Amos Tversky identified is this effect, called anchoring and adjustment. Meir Statman asked subjects this question:
“In 1896 the Dow Jones Industrial Average (DJIA) was at 40. At the end of 1998, the DJIA was at 9,181. The DJIA is a price-weighted average. Dividends are omitted from the index. What would the DJIA be at the end of 1998 if the dividends were reinvested every year?”
The correct answer is 652,230. Surprised? You may have been subject to the anchoring and adjustment effect. By starting at 9,181 and computing change from there, you are statistically more likely to guess a number close to that reference point.
Buying by the pack
The tenets of behavioral economics have profound implications for biases traders exhibit that have not predicted by mainstream models of valuation and pricing. Over the coming years these concepts will become better known and produce not only better predictive financial models but allow individuals to become better investors. Cognitive illusions and biases cannot be erased, just as one can’t help but imagine the lights dancing on a movie screen as real people. Traders seeking to avoid these mistakes would do well to identify these biases in their own trading and create incentives for avoiding them. Just as smokers are willing to pay more by the pack to limit their smoking, developing trading programs that discipline at a small cost (for instance, liquidating trades with a certain loss that perhaps have a potential for future profit) can prove useful.
“Trading Futures and Options on Futures involves substantial risk of loss and may not be suitable for all investors. Each investor must consider whether this is a suitable investment.”