Stripping the trading floor off its cliches
WE'VE all heard the clichés: 'Buy the rumour, sell the news'; ' Sell in May and go away'; ' You sell when people are greedy and buy when people are fearful'. And my personal favourite, stating the obvious as if it was an epiphany, 'Buy low, sell high'. If you ever had the joy of working as a trader, then you have definitely heard those phrases at least once in your lifetime. And I've definitely heard them and many more as a previous derivatives floor trader in Chicago and Toronto. If it's that easy, then why isn't everyone sleeping on a mattress full of cash?
So what it is like to be a trader you're wondering? Well, there is a lot of shouting, a lot of headaches and a lot of risk. One minute, you can buy a new car; the next, your house is gone. But if you get it right, it's all worth it in the end. As with anything else, there is a formula to follow if you wish to be a successful trader. Using an optimised, back-tested combination of technical and fundamental analysis, you should be able to reach a 60-70 per cent success rate on trades. So why is it that 98 per cent of day-traders undergo significant, sometimes life-shattering, losses?
The common perception is that the market is the enemy. Actually, the real enemy is sitting on our shoulders - it's your own head: fear, ego, overconfidence, greed ...
The biggest risk faced by traders comes from their own emotional thought processes; the psychology of fear! Fear of missing out on an opportunity, fear of suffering a loss, of reversing a profit through paralysis or greed (and I still do that after 20 years) and the reluctance to be plain wrong. Naturally, a real trader must juggle with all of these issues in microseconds. Let me illustrate my point. You enter into a long position (that is, you pur- chase shares). After a few days, you are making a 5 per cent profit - your trading system worked. Time to get out?
Decisions, decisions … and don't forget Murphy's Law. If you get out, you will watch the stock double the next day. If you don't, it will certainly move into a losing position. The problem here is that of selective memory. According to Collinsdictionary.com, selective memory is "an ability to remember some facts while apparently forgetting others, especially when they are inconvenient". As normal humans (yes, traders fall into that category too), we tend to remember what hurts us the most. So we focus on the losses, and promise ourselves: "The next time, I will close my position earlier/let my winnings run". Of course, for the next trade, our dear head - which is very useful for remembering phone numbers but sometimes subject to hysterical outbursts - leads us through the same process and we repeat the mistake.
The most effective way to combat this fear is threefold: discipline, data and a written plan. Yes, each trade needs to be put into writing before it is executed; technique, entry point, order details, emergency exit if you are wrong, profitable exit strategy (for instance, trailing stop-loss order), etc.Sounds like work? You bet it is. Solid data is also a must. Daniel Kahneman, one of the pioneers of cognitive finance, explains that heuristic behaviour, akin to the rule of thumb, is diametrically opposed to hard facts which are based on - you guessed it - data.
The best way to avoid selective memory is to keep a track record of all trades - and the discipline to follow your written plan. It is also important to step back and reassess your trading strategy from time to time to ensure that you haven't lost your way and moved into a "gambling" mindset. Another aspect that determines your success rate as a trader is your level of knowledge and your willingness to spend time and effort "paper trading". Paper trading entails going through the complete transaction using live data, including analysis, plan, etc without pushing the "ENTER" button at the end.
Of course, with no real money at stake, your behavioural biases might not resurface but your success rate will improve. The more experienced you are, the easier this will become for you. It is also considered wise to back test your strategy for up to five years thereby ensuring that it is robust to all possible market conditions. Many software packages provide this function.
Although trading occupies little space in the academic curriculum of most universities, it is the ultimate responsibility of educational institutions to bridge the gap between theory and practice and prepare students for the challenges they will face in the workplace. The American University of Sharjah has taken this commitment a step further by creating an interactive trading floor designed to be the exact duplicate of a typical trading room found on Wall Street or in a DIFC investment firm, including the same live feeds, industry software and analytical tools.