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USING LEVERAGE

Leverage seems like such a wonderful thing when traders first learn about it. "You mean I can invest the equivalent of $10,000 worth of equities by only putting $500 down?
......Wow, this is easy money."

The futures markets are the primary site for such leverage, but much the same can be accomplished with options.

The idea is is simple. Because of your vast experience, you (think you) know what is going to happen in your given market, so why not trade with leverage. A new trader in the futures markets might recall how he "knew" the oil market was going to go up last week, which it did. He forgets that oil went down first, then up, after his "call". He then looks at the margin requirement for one oil contract, say 3000 (this number constantly changes based on volatility and the broker you use). He then will divide his account balance, (in this example assume 30,000) by that margin number, realize he could have bought 10 crude oil contracts last week. He knows that the rise in the price of oil was $2, so with a little multiplication he can see that he could have made 20k if only he had acted on his knowledge last week. The trader never seems to think about the opposite, what could have happened to his account if oil had gone down. In addition, he doesn't think about the normal vacillations in price that might lead his account to be down at some point, even if it eventually is a winner.

Leverage can be a killer. There is nothing like the pain that comes with an over leveraged position, and the subsequent margin call. Good traders recognize that adequate capitalization is a key part of trading success. That means, do not leverage excessively! Never forget that improper use of leverage is one of the most common trading mistakes

TRADING WITHOUT A PLAN

This is just what it says. Your plan for the day is "to trade". You have no plan other than that.You have not reviewed the long term charts, short and intermediate term charts, volume for the prior day, previous day's trades including high, low largest volume areas. You have not looked at sympathetic markets, nor have you checked overnight markets, overnight news, and economic calendar for the day. You know nothing about current volatility, and have not checked your trading stats in weeks. You start off with the idea of day trading, but who knows.......if a longer term trade comes along that is a "no miss" you will take it. In fact, your trades may start as "day" trades and turn into long term trades because you want to be "flexible".

Go to the bank. You are going to need more money. Never trade without a plan................and once you have a plan, then Trade it!

FAILING TO TRADE YOUR PLAN

This may seem the same as number 1. It is not.

Let's say that you recognize that your market is in a trading range. For weeks this particular market has hit previous highs and retreated, and bounced off of previous lows. You thus decide that with no new of importance coming out today, you will sell highs, and buy lows. Once into trading however, the market is slow to do anything. It then begins a move toward the recent highs and you “know” that it will test them. “Why wait?” you think, since it is bound to test higher, so you buy now.....at the market. (the price you pay is unimportant if you KNOW that you are right!) Nothing happens, so you exit the trade with a small loss.

Later in the day the market does test the recent highs. It fails and you sell....GOOD! But then it mounts another test and goes through the highs, so you quickly take a loss and reverse and go long. T he market plugs along slightly higher, but fails again, drops like a rock with no more buyers, and you are left long with entry at the highs (when your plan was the opposite)

Develop a Plan. Trade your plan, failing to do so is a very common trading mistake.

TRADING UNPREPARED

You may have a plan, a good plan. It may be well thought out and one which will provide you with some degree of success in the long run.
You still must prepare to trade that plan

What does that mean?

Preparation is essential. Every day you must know the environment in which you are to begin trading for that day. Things may, and often do, change intra-day, but you must know where your starting point. This includes:
What phase is your market in over the Long Term? (bull, bear, balance)
What phase is your market in over the Intermediate term?
What phase is your market in over the short term?
How did yesterday's trading go? (was the market up or down and how did it get there)
(let's suppose the market ended higher, but intra day it had reached a longer term previous high and fallen back sharply........this is important)
What was yesterday's range?
What was yesterday's volume? (market hit new highs on terribly low volume....watch out!)
What happened in the overnight markets?
What happened in foreign markets?
Was there any news of importance since the close?
What is on the Economic Calendar for the day http://www.bloomberg.com/markets/economic-calendar/
What is happening in other markets of importance?
Where is your market positioned to open this day? (balance, higher, lower)
What has volatility been like recently?

All of this is essential for you to understand where you are to begin the day. The key to interpreting data is understanding context. You must know your current environment in order to correctly interpret market activity. This trading mistake can be costly.

TRADING WHEN YOU ARE NOT FIT TO TRADE

Trading involves an enormous amount of self discipline, and mental acuity. In order to trade well, you must be at your best both mentally and physically.

Mark Cook, of “Market Wizards” (Schwager) fame once told me of a period he went through where he was not earning money. For Mark this was quite unusual as his winning percentage has been nothing short of astounding. He only recognized the problem retrospectively (he has kept countless journals of his trading activity over the years, and they line the walls of his office). It was only then that Mark realized the issue. Not only had his health been sub par throughout this period, but his had been dealing with stressful family issues as well, including his father's illness.

We Must prepare for trading as you would an athletic event or a college exam. If you are not in peak mental and physical condition, be aware of that fact. You may choose to only watch the markets that day, or to trade only specific setups with much less capital than usual. Intution is important to traders. This is not instinct, as if you are born with it, but intuition, “the ability to understand something immediately, without the need for conscious reasoning” This comes from years of study and screen time and is often impossible to accurately assess.........but it is there for all good traders. . It is the incredible brilliance of the human mind that allows it draw upon an accumulation of knowledge and experience when confronted with uncertainty. It is “how you turn experience into action”. It is what caused pilot Chesley “Sully” Sullenberger to know that his with both engines failed and a plane full of passengers flying over the most densly populated area in the United States, his only out was to land on the Hudson River. That was not in the flight training manuals. Intuition is what helped Gene Kranz direct the team efforts in Houston that were able to bring Apollo 13 safely back to earth under circumstances no one could have predicted. Intuition is invaluable. Trade when you are not fit to trade, either mentally or physically, and you are trading without one of your most valuable assets; your intuition.

OVERTRADING

My biggest fault. No Question. There is more than one way to overtrade. You can trade too often or you can trade with too much principal. Either method can be one of the quickest ways to “blow up”. A basic key to trading is knowing that you have a basic system, or setup, that will allow you to beat the market more often than you lose. This can be a high frequency setup with less gain, or a low frequency setup with greater gain. The key is that it work out to a winner over time. Overtrading from a frequency standpoint involves you trading more frequently than your setup appears.

The other, and I think more common, way to overtrade is to do so via investing more capital into any given trade than your money management system allows, ie you come across a trade that you “know” will win, so why not invest more money into this trade? You therefore sink a large sum of your capital into this no lose situation.......all too often to find out you “lose”.

Overtrading comes from focusing on the prize instead of the potential risk. It is suicidal in trading, a lethal trading mistake. It is a reflection of poor discipline and lack of self control.

Read any of the market wizard books by Schwager. Find one example of a trader in those books (all are successful beyond your dreams) who does not use discipline in trading frequency or capital allocation. There are none. It cannot happen. You may win initially. You may even win often. But in the end statistics says that you will lose, and likely lose a lot, if not all.

DO NOT OVERTRADE!!!

TRADING ON TIPS OR ADVICE FROM OTHERS

Read my story in the "About me"section. It is true. Granted, I was going through a divorce and was not exactly in the right mental frame of mind to handle the crash that came in 2000. That may have played a role. (I certainly tell myself it did lest I have to take the blame for complete stupidity). Nonetheless, it is a true story of a guy who made a huge trade (overtrading) on a piece of advice. It turns out that the guy giving the advice was wrong. So what now. Guess what …................... the guy giving the advice laid no ground rules for what to do in a situation in which he was wrong (because he is never wrong). Guess What else............they guy giving the advice was not available in my “time of need”. So what do I do now. Who will give me advice now? That is the problem with trading on advice or tips. Trading is not a static situation. Trading is a very dynamic situation that requires minute by minute assessment. As a mentor of mine used to say.......”make the trade, then monitor it”. Why must you monitor the trade? You must monitor your trades because things change, unexpected events occur, and the market sometimes simply does not react as anticipated. With this in mind if you make trades based on tips or advice, when the unexpected occurs you will be left trying to decide what to do. Where will your tip come from then?

You are the one who has decided to trade. You must be responsible for your trades....alone.

POOR MONEY MANAGEMENT

Ok, so you develop a system, a good system. You test it. You test again, and again. It works. Now you trade.

But........how much do you trade? How much of your capital can you risk on your first and any further given trade? Maybe 10%? No it's a really good system. Maybe 20%? Yes, 20% should work if it is a really good system. That's only 1/5 of your capital and you have tested and tested again in a variety of markets. You know this system is good. You give it some more thought. You don't want to risk too much, but neither do you want to risk too little and delay your sure to come wealth. Well, you decide, “I know my system is good, but I plan to be extra conservative. I will only risk 15% of my capital on any trade.” You reason that you would have to be wrong seven times in a row to lose all your money with this plan and of course that is quite improbable. You know this because you are well aware of what the odds would be in tossing seven consecutive heads with coin flips, and that system is only successful fifty percent of the time. Your system is much better than that. 15% risk will be just right.

Let's take a moment to flip over to our book reviews and grab the one entitled “Inevitable Illusions”. What a name. We quickly open a page and find the following example:

Look at the following sequences of the results of tossing a coin seven times (h=head, t=tails)

• hhhhttt
• thhthtt
• ttttttt

• which is more likely to be the true result?

  Oh crap. You recognize that there must be a trick here. You know that the answer is likely sequence number two, but why would this question be asked if that were the answer. It must be sequence number one. But that can't be right. You know that does not look random. You are not sure. But then one thing you do know, it is not ttttttt. Seven tails in a row. That is surely not random. You read the book. You find out that probability theory tells you that in seven toses of a coin each of the three sequences is equally likely.

  You redesign your money management plan.

  Money Management is extremely important. The best edge or system will fail with an improper money management plan unless it is 100% successful. No plan is successful all of the time.

  Your money management plan must take into consideration your success rate, your expected greatest loss, and your win/loss ratio (in most systems the amount of your average win is not the same as the amount of your average loss).

  The Kelly Formula is %capital to invest = Historical Winning % of system – (1-W)/Historical Win / Loss ratio

  There are many other approaches to proper money management. Consider the writings of Ralph Vince. His approach is excellent but geared towards those fluent in mathematics.

  Portfolio Management Formulas : Mathematical Trading Methods for the Futures, Options, and Stock Markets Ralph Vince

  NOT RECOGNIZING CONFIRMATION BIAS

  Confirmation Bias. This happens to us all. In trading it is deadly. Click Here!for wikepedia's definition.

  Several years ago shortly after I first moved to town there was a buzz amongst the physicians In town because of a stock called Healthsource. Healthsource was an HMO. It had been started when the HMO craze first began and the company had essentially forced local physicians to become shareholders in order to maintain access to their patients. A few years later what had started as a five or ten thousand dollar investment that most of the docs thought they would never again see, had morphed into a holding worth twenty times as much. This of course caused quite a stir. The physicians were no longer quite as agitated with all the heretofore absurd policies of the company and began instead to talk of the professional manner in which Healthsource was being run. I was an innocent bystander having come to town too late to be forced to be a shareholder. Initially the stock price could only go up. Despite the fact that these physicians were allowed to “cash out” their investment, many did not. This was the 90's and the internet boom had yet to begin, but we were definitely in a bull market. These were also the advent years of “Motley Fool” and other internet stock information. Then Healthsource stock fell in value. It fell some more. Everybody had a theory about why the share price was falling, but strangely enough I noticed an odd phenomenon. The guys who had chosen to sell could see clear implications for a dismal outlook for the stock whereas the persistent shareholders saw the opposite; this was only a temporary setback which was to be expected and the future for the company was bright. Now partly you might expect this because the dim outlook had made the sellers sell, and vice versa But this was more than that. It was universal and each piece of new information was interpreted as good or bad, solely by whether or not one still held the stock. This was my introduction to confirmation bias. It would not be our last interaction..

  Klein (Sources of Power...how people make decisions) defines confirmation bias: the search for information that confirms your hypothesis – even though you would learn more by searching for evidence that would dis confirm it.

  We are all subject to this error in judgment and it pervades our society today, though few take the time to recognize it, or more importantly its destructive power. I noted that I would often hold stocks, futures. Options especially, too long. I would review my trades, often losers, and in the process say to myself “why didn't I see that?” At one point I noticed this to be such a problem that I made a rule. If (in the process of monitoring my trade) I came across a situation in which things were not progressing as expected and demanded reconsideration......... I would exit my trade, even if only for a few minutes, while I considered my next move. There is no doubt that I thought more clearly once out of the trade. Silly, but true.

  Confirmation Bias removes a trader's objectivity. You work diligently to learn to asses markets and quickly become biased the moment you initiate a trade. You cannot become immune to this malady but you can become aware of it and deal with it accordingly.

  "Traits of fear, hope greed, pride-of-opinion, and wishful thinking are so strong in the human breast that they prevent one from being objective. Objectivity.....is imperitive. ......subjective reasoning leads to opinionated conclusions. If one relies stubbornly on his own opinion......he is likely to stantd on it.....right or wrong. No trait is stronger perhaps, than that of defending one's opinion and of being unwilling to admit error in judgement."
  Humphrey Neill......who traded in the 1920's

  It is important to understand the good and the bad of intuition. Review intuition.

  TRADING WITHOUT STOPS

  

  Every trader should be familiar with stops. A stop is nothing more than an order to close a position; sell for long positions and buy for shorts. Hopefully if you execute your plan accordingly you will not need to ever invoke a stop. However....unexpected things happen, like terrorist attacks, a, resignations, war, etc. You should always protect your position with a stop. The stop can be set well out from your entry, and only exercised in the case of a sharp market movement against your position. But it would provide some protection against disaster. Are stops foolproof. NO! You may find that there are no orders around your stop at the time that it is invoked, and thus your exit price is far worse than expected. Because of this, some people would rather use stop-limit orders. Essentially these orders say “close my position at this price if, and only if you can fill within this given price range”

  Example:
  You are long a stock at 50. You set a stop at 40. A terrorist attack occurs , the market tanks and everybody pulls their buy orders. The stock falls to 47/43/36 and finally ends up around 34. When it traded at 42 it then broke sharply to 37, with no trades in between. Your exit price is 37.

  Same scenario and you enter a stop limit order for the long position. The order reads sell stop 40, limit 38. When the stock trades through 40 to 37, there are no trades at 38,39,40. You do not get filled and you still own the stock.

  Finally stops can be painful.
  Using the scenario above the attack occurs. News hits the exchange. The stock trades sharply lower and you are out. Quickly however it becomes apparent that things are not as bad as expected. The market rallies sharply. You get home from work to find out that you sold at 37, but the stock ended the day at 46. Ouch!

  Nonetheless, you should use emergency stops.

  FAILING TO TAKE RESPONSIBILITY FOR YOUR TRADES

  You make a trade purchasing near term call options on a specific equity. Your intent is to hold the options for less than a week and you are quickly profitable. The following morning the company CEO resigns because of health issues, and he announces his dismal prognosis. The stock plummets and your money is gone. You write a letter to the CEO criticizing his selfish resignation, and the effect it had on the company stock.

  You are short bonds, knowing that the long bond yield must increase in light of all the government borrowing. You are making money. A terrorist ignites a bomb in a New York subway and in an instant, you are down thousands of dollars. You are angry with the events and know how much money you would have made otherwise.

  You are day trading the S+P futures and having a productive day. Your daughter comes home from school and comes into your office to talk about her day. Soon you notice your trades are under performing and by the end of the day you are down several thousand dollars. You walk downstairs, find your daughter and criticize her for interfering with your trading. Were it not for her, you would have had a wonderful day.

  Do any of these sound familiar? Maybe not. Perhaps your story is different. But trading is like life, and none of us like to be on the losing end. It is easy to find blame elsewhere.

  I used to play golf with some very capable golfers. I noticed that after missing a putt, one of those quite good players, Mark, would always criticize the green, the noise, the shadows, and even the birds that interfered with his concentration. He would always blame some outside interference for his miss. I asked Mark's friend about the comments one day and was told: “Well that's just Mark. He thinks he is a great putter. So when he misses he has to blame something and it can't be him. Overall....he went on...... It really works out well because it allows Mark to keep believing that he is a great putter. He steps up to every stroke with confidence knowing that he has not missed any putts because of any mistakes on his part”

  Wow!

  That may work in golf. It does not work in trading.

  Think about this............Why does every good trader keep a journal? It is not in order to document external causes of failed trades. The journal is a method of review, of analyzing performance and noting areas in which improvement can occur. Through committed efforts to review, and correct shortcomings that led to poor outcomes, the trader improves. Self critique is essential. Without it the trader is caught in a time warp where he never becomes a better trader, but instead continues to make the same mistakes trade after trade.

  You will make mistakes. In order to improve you must: take responsibility for your mistakes analyze your trading errors that led to the problem and make diligent efforts to correct the issues

  NOT KNOWING YOUR MARKET

  Mark Cook, the great S+P trader from Market Wizards fame, once told me a story of a bond trader who came to him for help. It seems the bond trader was wildly successful trading from the pit at the CBOT in Chicago. This particular gentleman had made a great deal of money off his own account from regular floor trading (included a seven figure income the prior year), and he traded exclusively the thirty year bond futures. The trader had come to Mark to learn how to trade S+P futures. Mark had asked why the trader wanted to change markets, and tried to persuade him not to do so. Nonetheless the trader was determined and so he spent several days with Mark in a seminar learning about S+P futures. When the end of the week came, Mark once again approached the trader and suggested that not stray from what he “knew”.......keep trading bonds. Several weeks later Mark called for follow up only to hear a depressed and somewhat dismal voice on the other end of the line, from a guy who had lost enormous sums of money.

  Why would something like that happen?

  

  Haven't you heard gurus like Linda Raschke explain that their methods will work for all markets? Why would someone be able to trade bonds, but not equities?

  I asked this question to a successful trader friend of mine one day and got the following response: Markets are like women. Overall they are quite similar and share many characteristics. But as you get to know them you find each is a little different than the next. Approaches that may work well for one woman, might not work at all for another, and you only find out what is best by spending countless hours with the one you are pursuing.”

  I trade the long bond, oil and S+P futures. The three markets are quite different. In terms of range, volume, and volatility. You must know the market you trade.

  NOT KEEPING A TRADING JOURNAL

  

  You want to trade? You want to be successful? Keep a journal!

  Don't allow yourself to make the same mistakes again and again. Revisit your trades after the fact: Winner & Losers. Document what you were thining when you made your trades. If you can, include charts to refresh your memory when you reread this material. Jot down quick notes, but enough that you will learn from this as you review it. Every successful trader keeps a trading journal of some sort

  A LIST OF SOME OTHER COMMON MISTAKES

  • DOUBLING DOWN ON LOSERS
  • ALWAYS PLACING MARKET ORDERS
  • CHANGING STOPS AFTER INITIAL PLACEMENT TO AVOID EXECUTION
  • ALTERING YOUR APPROACH TO TRADING SIMPLY BECAUSE YOU ARE UP / OR DOWN
  • SEEKING ADVICE
  • ALWAYS WANTING TO SELL AT THE TOP, OR BUY AT THE BOTTOM
  • CONSTANTLY CHANGING YOUR TACTICS
  • BELIEVING THAT THERE IS A HOLY GRAIL...OR ANSWER TO TRADING